December 2012
The Financial Sector and
Sustainable Development:
Logics, principles and actors
Umberto Pisano, André Martinuzzi & Bernulf Bruckner
ESDN Quarterly Report N°27
European Sustainable Development Network
Authors:
Umberto Pisano (ESDN Office)
André Martinuzzi (ESDN Office)
Bernulf Bruckner (LRTC - Liquidity Research, Training and Consulting Ltd., Austria)
Contact:
ESDN Office at the
Research Institute for Managing Sustainability
Vienna University of Economics and Business
Franz Klein Gasse 1, A-1190 Vienna, Austria
E: [email protected]
T: +43-1-31336-4807
English proofreading: Megan Ahearn, University of British Columbia, Canada
© 2012 European Sustainable Development Network (ESDN)
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3
ESDN Quarterly Report 27 – December 2012
The Financial Sector and Sustainable Development
Logics, principles and actors
by
Umberto Pisano, André Martinuzzi & Bernulf Bruckner
This ESDN Quarterly Report (QR) offers insight into the relationships, linkages, and differences between
the financial sector and sustainable development. Although we recognise the vastness of the task, which
is mainly caused by the complexity of the financial sector, we try to provide an explanatory journey and a
fertile environment for further reflections and discussions, especially where linkages and differences
with sustainable development are portrayed. Despite this complexity, this QR tries to communicate the
main financial notions in a language that is as simple as possible, with the intention of avoiding an
overload of technicalities. The QR does not aim to be exhaustive, but should uncover those links that are
particularly relevant for sustainable development and SD governance. The report is based on the
Discussion Paper of the 8th ESDN Workshop, which it expands in all chapters that are also informed by
the debates at the workshop and additional desk research.
The QR is structured into four main sections: an introduction, two main chapters, and a conclusive
section. At the end, a reference list and two annexes are also provided. The brief introduction is a short
overview, outlining the essential points that are touched upon throughout the Quarterly Report. In the
first chapter, the objective is to describe the main features of the financial sector, its logic, its actors, and
its main institutions, also reflecting upon its linkages with the real economy. The second chapter then
introduces the concept of sustainable development and describes the so-called sustainable development
principles that help to operationalize such a concept. The main differences with the financial sector are,
therefore, analysed together with possible ways of intervention in order to close the gaps between
them. Special attention is then attributed to the potentials to enable sustainable development financing.
Finally, some conclusions are drawn at the end of the report where we also propose reflections and
points for discussion. In the course of writing this report, we developed a Framework for Sustainable
Development and the financial sector where we defined six SD principles and compared them with the
logic of the financial sector (please see page 27). In Annex I, we provide a Glossary with the most
important terms and concepts around the financial sector that should help readers with short and
precise explanations. Two interviews with Professor Stefania Rossi (University of Cagliari, Italy) and
Alexander Welzl (senior researcher at Economica, Austria) about recent developments in the financial
sector and links to sustainable development can be found at the end of the report in Annex II and III.
4
Contents
Introdu cti on
6
1.
The financial se ctor and the ‘real’ economy
8
1.1.
1.2.
1.3.
The financial sector and its logic
The financial sector: financial markets, institutions and key actors
Links to the real economy
8
9
19
2.
Sustainable development a nd the fi na ncial sector
21
2.1.
2.2.
2.3.
2.4.
Sustainable development principles
The main differences
Regulations and interventions
Potentials to enable sustainable development financing
21
24
28
32
Conclusi on
42
References
44
Annex I
47
Annex II
Glossary
Interview with Stefania Rossi, University of Cagliari
Annex III Interview with Alexander G. Welzl, Economica
49
53
5
Introduction
The current
situation and
challenges
Currently, the global debate about financial reforms is very much ongoing. Recent
developments, like the Euro crisis, the financial and economic crisis, dramatic cuts in
public budgets etc., seem to suggest that the current set up of financial markets is no
longer adequate in economic, social, and political terms, neither in a short- nor in a longterm perspective, e.g.: the financial system increasingly dominates other parts of the
economy; the financial crisis of 2007-08 led to a dramatic reduction in the credit available
for individuals, businesses, and governments; the subsequent reduction in consumer
spending, government expenditure, and business investment has had a major impact on
economic growth and employment (Hewett, 2012); pressure is mounting by the
countries’ anxiousness of being downgraded on their credit-worthiness by global rating
agencies. This also led to intensive discussions in which policy areas to cut budgets, and
these developments, in general, put pressure on sustainable development policy and
sustainable investment, production, and consumption activities. At the same time, it is
increasingly obvious that the sustainable development of the economy and society
creates a crucial and fast growing demand for adequate financing and functional financial
instruments and markets, and is a substantial and crucial area in which to apply
sustainable finance and financial market policy. For instance, the challenges and
incentives for companies, consumer households, and public authorities to internalize
negative externalities have become a central issue when integrating SD considerations
into investment and management decisions (UNEP Finance Initiative, 2007).
The report and
its links with the
ESDN 2012
Workshop
This report is mainly based on the contents and structure of the discussion paper written
for the 8th ESDN Workshop which was held in Brussels in November 2012. The workshop
intended to scope the mechanisms and operational design of financial markets, explore
the functional and dysfunctional aspects from an SD perspective and, on this basis,
develop concrete fields of action for SD policy related to financing, financial markets, and
finance governance. The outcomes and discussions of the workshop have been included
in this report, as it maintains the intention to provide an orientation for SD policy-makers
in the debate around the financial markets and future policy options in their
administrations. Together with these themes, the report also takes advantage of and
incorporates the topics previously explored by two ESDN case studies that considered, on
the one hand, “Barriers and opportunities for taking a long-term perspective in the
financial market” and, on the other hand, reflected on “Sustainable investment: options
for a contribution to a more sustainable financial sector”.
The report’s
structure
The report is divided in two main chapters. After this introductory section, the first
chapter offers an overview of the financial sector, what it provides for the economy, and
how this plays out in practice. Therefore, the logic and concepts of financial markets,
different financial institutions and the main actors of the financial sector are outlined,
together with links to the real economy. In the second chapter, we discuss various
6
sustainable development principles and what they imply for policy-making in general, as
well as relations with the financial market in particular. The chapter continues with an
analysis of the main differences between the financial markets and sustainable
development, presents various interventions on the financial sector that could help
reducing the distances between the two arenas, and introduces the theme of financing
sustainable development. A concluding section follows, together with a reference list,
and a glossary of most important terms in Annex I. Finally, annex II and III represent two
interviews with researchers with the intention of providing more insights and adding
more perspectives on the topic.
7
1. The financial sector and the ‘real’ economy
Chapter in brief:
 An efficient financial sector is essential to a well-functioning economy: it allocates capital and
manages risks in an efficient way.
 The logic of the financial sector is one-dimensional and mainly related to the maximization of financial
profits and, especially, to return on investment.
 The financial sector is formed by the different financial markets and the various financial institutions.
 Financial markets are those in which financial assets (securities) can be purchased or sold; they
facilitate the flow of funds and, thereby, allow financing and investing. Five financial markets can be
distinguished: commodity market, money market, capital market, currency market, and derivatives
market.
 Financial institutions provide financial services for their clients and can be differentiated into
depository and non-depository institutions.
 To understand the links with the ‘real’ economy, important issues are to understand how capital is
allocated or invested, what reasons determine the decisions over an investment, and which
investments are preferred.
1.1. The financial sector and its logic
Financial sector:
allocate capital,
manages risks,
efficiently.
An efficient financial sector is essential to a well-functioning economy. Therefore, it
should serve in improving the efficiency of the economy as well as increasing its
productivity. In other words, it should be a means to the real economy. The financial
sector (or system) has, in general, a very straightforward set of tasks: Firstly, it has to
allocate capital, i.e. making sure that capital goes to areas where its return is highest.
Secondly, it should manage risks in a way that, using the ability to absorb risk, it allows
capital to go where higher return on investments can be made. Thirdly, it is also
supposed to perform these tasks efficiently - therefore, at a relatively low cost (Stiglitz,
2010)1.
The logic
The logic behind the financial sector is one-dimensional and mainly related to the
maximization of financial profits and, especially, to the return on investment.
Understood as the net profit over the investment made, the return on investment is the
main concern for financial markets. This is also related to a very short time frame in
which the pursuit of short-term profits – or immediate gain as close as possible to the
present time – is also a crucial feature of financial sector logic. A distinctive characteristic
of financial markets is the goal of managing risks and dealing with uncertainty. To give
an example: thanks to financial markets, businesses make use of the so-called hedging
1
Joseph Stiglitz’s final keynote lecture at the Sustainable Business Series, Edinburgh International Book Festival. (see also:
http://www.youtube.com/watch?v=_SfjQl7L-74).
8
practice, which represents a risk management strategy used in limiting or offsetting
probability of loss from fluctuations in the prices of commodities, currencies, or
securities2. This example shows an extremely important service that financial markets
provide to the real economy, namely managing risks, avoiding high losses, and allowing
smoother operations. Conversely, it is also true that since higher risks leads to higher
profits, if someone is not averse to risk, he/she will accept the possibility of losing the
investment for a larger return. This also leads to the possibility that individuals in the
financial sector who are tempted by larger profits might lose their ability to assess risks.
Another important aspect of the logic of the financial sector is linked to the risk feature
we described above, and concerns the evidently inappropriate remuneration structures
of some financial institutions. These so-called “bonuses” have been a contributory factor
of excessive and imprudent risk-taking in the financial sector, and, as outlined in the
EU’s Directive 2010/76/EU (on capital requirements for the trading book and for resecuritisations, and the supervisory review of remuneration policies), this partially led to
the failure of individual financial institutions, and then to systemic problems. It is argued
in this Directive that remuneration policies that give incentives to take risks can
undermine sound and effective risk management and exacerbate excessive risk-taking
behaviour. For instance, as pointed out by Sheng (2011) “[s]ince wages and bonuses
make up between 30 to 70 per cent of financial sector costs, there are tremendous
incentives to generate short-term profits at higher risk”.
The financial sector is also highly technical and employs well-prepared and well-paid
specialists that work constantly in an extremely competitive environment. Global
opportunities, speed, and the need for information are also important features of the
sector. Finally, another important feature of the financial sector that cannot be neglected
regards the role of debt creation, which assumes constant and continuous growth of the
economy.
1.2. The financial sector: financial markets, institutions and key
actors
Financial markets
2
The financial sector is formed mainly by financial markets and financial institutions. A
financial market is a market in which financial assets (securities), such as stocks and
bonds, can be purchased or sold. Funds are transferred in financial markets when one
party purchases financial assets that were previously held by another party. Financial
markets facilitate the flow of funds and thereby allow financing and investing by
households, firms, and government agencies (Madura, 2011). In other words, financial
markets are crucial in promoting greater economic efficiency, by channelling funds from
people who do not have a productive use for them to those who do. Indeed, wellfunctioning financial markets are a key factor in producing high economic growth
http://www.businessdictionary.com/definition/hedging.html
9
(Mishkin and Eakins, 2012).
Households and businesses that supply funds to financial markets earn a return on their
investment; the return is necessary to ensure that funds are supplied to the financial
markets. If funds were not supplied, the financial markets would not be able to transfer
funds to those who need them. Those participants who receive more money than they
spend are referred to as investors (or surplus units). Those participants who spend more
money than they receive are referred to as borrowers (or deficit units).
Securities
represent a claim
on the issuer’s
future income or
assets
Many borrowers, such as firms and government agencies, access funds from financial
markets by issuing securities. Also called financial instruments, securities represent a
claim on the issuer’s future income or assets (any financial claim or piece of property
that is subject to ownership). Issuing securities enables corporations and government
agencies to obtain money from surplus units and thus to spend more money than they
receive from normal operations.
Different financial markets
In the financial sector, there are different financial markets that are “created to satisfy
particular preferences of market participants” (Madura, 2011). Financial markets can be
classified in different ways and, therefore, their number can vary. We distinguish
between five financial markets, as these five seem widely acknowledged in the
literature: (1) commodity market, (2) money market, (3) capital market, (4) currency
market, and (5) derivative market.
(1) Commodity
market
A commodity is defined by the New Oxford American Dictionary as a raw material or
primary agricultural product that can be bought and sold (i.e. copper or coffee).
Therefore, commodity markets are markets where raw or primary products are
exchanged. These raw commodities are traded on regulated commodities exchanges, in
which they are bought and sold in standardized contracts.
(2) Money market
Money market securities are short-term instruments with an original maturity of less
than one year. These are financial instruments with high liquidity and very short
maturities. Money market securities are used to “warehouse” funds until needed. The
returns earned on these investments are low due to their low risk and high liquidity
(Mishkin and Eakins, 2012).
(3) Capital market
The capital markets exist to provide financing for long-term capital assets. Households,
often through investments in pension and mutual funds, are net investors in the capital
markets. Corporations and the federal and state governments are net users of these
funds. The three main capital market instruments are bonds, stocks, and mortgages.
When referring to money market securities or capital market securities, it is important to
distinguish between the notions of primary and secondary markets, essentially because
the transactions in the primary market and the transactions in the secondary market are
10
fundamentally different. Primary markets facilitate the issuance of new securities and
provide funds to the initial issuer of securities (for instance the issuance of new
corporate stock or new Treasury securities is a primary market transaction). Secondary
markets facilitate the trading of existing securities, which allows for a change in the
ownership of the securities; hence, these are financial markets in which securities that
have been previously issued can be resold (for instance, the sale of existing corporate
stock or Treasury security holdings by one investor to another is a secondary market
transaction).
(4) Currency
market
For funds to be transferred from one country to another, they have to be converted from
the currency in the country of origin into the currency of the country they are going to.
The currency market or foreign exchange market is the financial market where exchange
rates are determined. The foreign-exchange markets underpin all other financial
markets. They directly influence each country’s foreign-trade patterns, determine the
flow of international investment, and affect domestic interest and inflation rates. They
operate in every corner of the world, in every single currency. Collectively, they form the
largest financial market by far (Levinson, 2006).
(5) Derivatives
market
A market for derivatives is also in place and is very important. Derivative securities are
financial contracts whose values are derived from the values of underlying assets (such
as debt securities or equity securities) and are extremely useful risk-reduction tools.
Financial derivatives are so effective in reducing risk because they enable financial
institutions to hedge, which means to engage in a financial transaction that reduces or
eliminates risk. The most important financial derivatives that are used to reduce risk are
forward contracts, financial futures, options, and swaps.
Direct finance and
indirect finance
The flows in the financial system are shown in Figure 1 below. Those who have saved and
are lending funds (lender-savers), are at the left, and those who must borrow funds to
finance their spending (borrower-spenders), are at the right. Usually, the main lendersavers are households. On the other hand, the most important borrower-spenders are
businesses and the government. The arrows show that funds flow from lender-savers to
borrower-spenders via two routes. In what is called direct finance, borrowers borrow
funds directly from lenders in financial markets by selling them securities (also called
financial instruments), which are claims on the borrower’s future income or assets.
However, funds also can move from lenders to borrowers by a second route, so-called
indirect finance (Mishkin and Eakins, 2012), which involves a financial intermediary that
stands between the lender-savers and the borrower-spenders and helps transfer funds
from one to the other. A financial intermediary does this by borrowing funds from the
lender-savers and then using these funds to make loans to borrower-spenders. The
process of indirect finance using financial intermediaries, called financial intermediation,
is the primary route for moving funds from lenders to borrowers.
11
Figure 1: “Flows of
Funds Through the
Financial System”
Source: Mishkin and Eakins (2012)
Financial
intermediaries and
institutions
Although the media focus much of their attention on securities markets, particularly the
stock market, financial intermediaries are a far more important source of financing for
corporations than securities markets are. Financial intermediaries play an important role
in the economy because they provide liquidity services, promote risk sharing, and solve
information problems, thereby allowing small savers and borrowers to benefit from the
existence of financial markets. Additionally, financial intermediaries play a key role in
improving economic efficiency because they help financial markets channel funds from
lender-savers to people with productive investment opportunities. Without a wellfunctioning set of financial intermediaries, it is usually argued that it would be very hard
for an economy to reach its full potential. Also in this case, many distinctions can be
made. Therefore, the more encompassing notion of financial institution is helpful
because it allows being more inclusive and containing the financial intermediaries as
well. Financial institutions, institutions that provide financial services for its clients or
members, can be divided into:
1. Depository institutions (e.g. commercial banks, savings institutions, credit
unions) that obtain funds mainly through deposits from the public; and,
2. Non-depository institutions (e.g. finance companies, mutual funds, securities
firms, insurance companies, pension funds) that finance their investment
activities from the sale of securities or insurances.
In aggregate, commercial banks are the most dominant depository institution. They
serve investors by offering a wide variety of deposit accounts, and they transfer
deposited funds to deficit units by providing direct loans or purchasing debt securities.
Commercial banks serve both the private and public sectors, as their deposit and lending
services are utilized by households, businesses, and government agencies.
12
Savings institutions, which are sometimes referred to as thrift institutions, are another
type of depository institution. Savings institutions include savings and loan associations
(S&Ls) and savings banks. Like commercial banks, S&Ls offer deposit accounts to
investors and then channel these deposits to borrowers. Whereas commercial banks
have concentrated on commercial loans, however, S&Ls have concentrated on residential
mortgage loans.
Credit unions differ from commercial banks and savings institutions in that they (1) are
nonprofit and (2) restrict their business to the credit union members, who share a
common bond (such as a common employer or union). Because of the common bond
characteristic, credit unions tend to be much smaller than other depository institutions.
They use most of their funds to provide loans to their members.
Most finance companies obtain funds by issuing securities and then lend the funds to
individuals and small businesses. The functions of finance companies and depository
institutions overlap, although each type of institution concentrates on a particular
segment of the financial markets.
Mutual funds sell shares to investors and use the funds received to purchase a portfolio
of securities. They are the dominant non-depository financial institution when measured
in total assets. Some mutual funds concentrate their investment in capital market
securities, such as stocks or bonds. Others, known as money market mutual funds,
concentrate in money market securities. By purchasing shares of mutual funds and
money market mutual funds, small savers are able to invest in a diversified portfolio of
securities with a relatively small amount of funds.
Securities firms provide a wide variety of functions in financial markets. Some securities
firms use their information resources to act as a broker, executing securities transactions
between two parties.
Insurance companies provide individuals and firms with insurance policies that reduce
the financial burden associated with death, illness, and damage to property. They charge
premiums in exchange for the insurance that they provide. They invest the funds that
they receive in the form of premiums until the funds are needed to cover insurance
claims. Insurance companies commonly invest the funds in stocks or bonds issued by
corporations or in bonds issued by the government. In this way, they finance the needs
of borrowers and thus serve as important financial intermediaries.
Many corporations and government agencies offer pension plans to their employees. The
employees, their employers, or both periodically contribute funds to the plan. Pension
funds provide an efficient way for individuals to save for their retirement. The pension
13
funds manage the money until the individuals withdraw the funds from their retirement
accounts. The money that is contributed to individual retirement accounts is commonly
invested by the pension funds in stocks or bonds issued by corporations or in bonds
issued by the government. In this way, pension funds finance the needs of borrowers,
and thus serve as important financial intermediaries.
Figure 2 illustrates the relative sizes of the different types of financial institutions, based
on assets from the point of view of the United States of America. The percentage for
each type of financial institution indicates its proportion of the total dollars in assets held
by all financial institutions in the USA. Together, all of these financial institutions hold
assets equal to about 46 trillion dollars. Commercial banks hold the largest amount of
assets of any depository institution. They have $11.2 trillion in assets, representing 24
percent of the total assets held by all financial institutions. Mutual funds hold the largest
amount of assets of any non-depository institution. They have about the same amount of
assets as commercial banks. Pension funds have about $10 trillion in assets, or about 22
percent of all assets held by financial institutions.
Figure 2:
Relative size of
financial
institutions for
USA (% of assets in
dollars)3
Commercial banks
22%
Savings institutions
24%
Credit unions
Finance companies
4%
14%
Mutual funds
2%
7%
A European
perspective
3
4
3%
24%
Securities firms
Insurance companies
Pension funds
In the European Union, the European Central Bank (ECB)4 maintains lists of the following
three groups of institutions, based on information provided regularly by all members of
the European System of Central Banks (ESCB): 1) Monetary financial institutions; 2)
Investment funds; 3) Financial vehicle corporations. Therefore, in EU, definitions for
financial institutions are slightly different than USA, but with the intent of providing a
similar outlook of their sizes (as we did for the USA), we grouped them in four categories:
a) Credit institutions; b) Money market funds & Investment Funds; c) Insurance
Companies and Pension Funds; d) Financial Vehicle Corporations (FVC).
Adapted from Madura (2011); data from the Board of Governors, Federal Reserve System (2009)
See also: http://www.ecb.europa.eu/stats/money/mfi/html/index.en.html
14
Figure 3:
4.3%
Relative size of
financial
institutions for EU
(% of assets in
euros)5
Credit Institutions
14.7%
15.3%
65.8%
Money Market Funds &
Investment Funds
Insurance Companies &
Pension Funds
Financial Vehicle
Corporations (FVC)
As can be seen from Figure 3, the relative sizes of the different types of financial
institutions, based on assets, provide an overview from the point of view of the European
Union. Altogether, European financial institutions hold assets equal to about 50 trillions
of Euro. Credit Institutions hold almost two thirds of the total with the largest amount of
assets that equals about 33 trillions of euro.
Actors on the financial markets
There is a range of actors that play a crucial role in the financial sector. Although our
viewpoint is more directed towards the European Union, some international actors will
be also outlined to signify the strong global inter-linkages that characterize the financial
sector.
The ECB has to
maintain price
stability
The European Central Bank (ECB) is the main bank for Europe's single currency, the Euro.
The ECB was established as the core of the Euro system and the European System of
Central Banks (ESCB) with the primary objective of maintaining price stability through
influencing money market conditions and steering short-term interest rates. In other
words, the ECB controls both the supply of money (i.e. quantity of money) and its price
(i.e. the interest rate).
ESCB, Eurosystem
Together with the European Central Bank, two systems are in place in the European
Union: 1) the European System of Central Banks (ESCB) comprises the ECB and the
national central banks (NCBs) of all EU Member States whether they have adopted the
euro or not; and, 2) the Eurosystem is also in place, and comprises the ECB and the NCBs
of those countries that have adopted the euro. The EU national central banks (EU NCBs)
are also part of this system. They are owned by their respective states but are
independent by their constitutions.
5
Own elaboration; data from ECB, 2012
15
ESM
Recently entered into force in September 2012, the European Stability Mechanisms
(ESM)6 has been defined as the “cornerstone of the European firewall and an integral
part of the strategy to ensure financial stability in the euro area”. The ESM is an intergovernmental institution, based in Luxembourg, set up to provide financial assistance to
Eurozone Member States experiencing, or being threatened by, severe financing
problems, if this is indispensable for safeguarding financial stability in the Euro area as a
whole.
IMF
Another important actor is the International Monetary Fund (IMF) with its near-global
membership of 188 countries. The IMF supports its membership by providing: (i) policy
advice to governments and central banks; (ii) research, statistics, forecasts, and analysis;
(iii) loans to help countries overcome economic difficulties; (iv) concessional loans to help
fight poverty in developing countries; and (v) technical assistance and training to help
countries improve the management of their economies.
Rating Agencies and
the ‘Big Three’
Since 1975, starting in the USA, a few laws and regulations (i.e. Gramm–Leach–Bliley Act
of 1999; Sarbanes–Oxley Act of 2002; Credit Rating Agency Reform Act of 2006) gave
rating agencies a very important role in the financial sector 7. A credit rating agency (CRA)
is a company that is in the business of rating the credit worthiness of debt. It does so by
rating issuers of debt obligations and also by rating the debt instruments
themselves. Credit ratings are meant to provide easy-to-use measurements of relative
credit risk so that investors can make informed choices. The idea is to facilitate
transactions and lower costs for both borrowers and lenders. As a matter of fact, the
above mentioned laws ‘forced’ public authorities to ask for the rating of at least one of
the so-called ‘Big Three’ credit rating agencies: Standard & Poor's, Moody's Investor
Service, and Fitch Ratings. Moody's (40%) and S&P (40%) control 80% of the market.
Third-ranked is Fitch Ratings that has about a 14% market share8. The remaining 6% of
the market is shared by approximately one hundred smaller agencies.
US Federal Reserve
In this array of actors, national banks of major and powerful countries also have an
important part in the financial sector, such as the US Federal Reserve. The US Federal
Reserve System (also known as the Federal Reserve, and informally as the Fed) is the
central banking system of the United States. The Congress established three key
objectives of its monetary policy: (1) maximum employment, (2) stable prices, and (3)
moderate long-term interest rates.
6
see also: http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/132734.pdf
See also: Wall Street Journal, 2009 at: http://online.wsj.com/article/SB123976320479019717.html
8
http://www.fairobserver.com/360theme/credit-rating-agencies
7
16
The World Bank
Another key international actor is the World Bank Group, which was conceived in 1944
to reconstruct war-torn Europe, and has evolved into one of the world’s largest sources
of development assistance, with a mission to fight poverty by helping people to help
themselves. The World Bank Group is formed by five institutions, but only two form the
World Bank9:
1. the International Bank for Reconstruction and Development (IBRD), which lends
to governments of middle-income and creditworthy low-income countries; and,
2. the International Development Association (IDA), which provides interest-free
loans (also called credits) and grants to governments of the poorest countries.
G-SIFIs
In terms of crucial actors in the financial sector, a last mention goes to the so-called
Global Systematically Important Financial Institutions (G-SIFIs)10, which are financial
institutions whose distress or disorderly failure (because of their size, complexity, and
systemic interconnectedness) would cause significant disruption to the world’s wider
financial system and economic activity. In November 2011 the Financial Stability Board
published an integrated set of policy measures to address the systemic and moral hazard
risks associated with systemically important financial institutions (SIFIs). In that
publication, the FSB identified an initial group of G-SIFIs, namely 29 global systemically
important banks (G-SIBs), using a methodology developed by the BCBS. The FSB and the
standard setting bodies are extending the SIFI framework to other systemically important
financial institutions, and they have updated the list first developed in November 2011
which included 29 financial institutions as the G-SIFIs: four were Asian (3 JP and 1 CHN),
eight from USA, four from France, four from the UK, two from Germany, two from
Switzerland, and one respectively from Belgium, Italy, Netherlands, Spain, Sweden. In the
updated list, two banks have been added (BBVA and Standard Chartered) and three
banks removed: Dexia, as it is undergoing an orderly resolution process; Commerzbank,
and Lloyds, as result of a decline in their global systemic importance 11.
Box 1:
List of 28 G-SIFIs
in alphabetical
order
(adapted from FSB,
2012)
Bank of America
Bank of China
Bank of New York Mellon
Barclays
BBVA
BNP Paribas
Citigroup
Credit Suisse
Deutsche Bank
Goldman Sachs
Group Crédit Agricole
Groupe BPCE
HSBC
ING Bank
JP Morgan Chase
Mitsubishi UFJ FG
Mizuho FG
Morgan Stanley
Nordea
Royal Bank of Scotland
Santander
Société Générale
Standard Chartered
State Street
Sumitomo Mitsui FG
UBS
Unicredit Group
Wells Fargo
9
The International Bank for Reconstruction and Development / The World Bank. 2011. A guide to The World Bank. 3rd ed.
See also: http://www.financialstabilityboard.org/publications/r_111104bb.pdf
11
See also: http://www.financialstabilityboard.org/publications/r_121031ac.pdf
10
17
To give an idea of their magnitude, power and relevance, we provide hereby two
examples. First, Deutsche Bank holds assets for more than $2,844 billion (Forbes,
2012)12, which is a little higher than the sum of the national GDPs of Spain, Portugal,
Poland, Austria, and Hungary together, which are countries with a combined population
of around 115 million people.
As a second example, for instance, the European Union has a population of 495 million
inhabitants, and a total GDP ranging between $16 and 17 trillion. This value is very
similar to the sum of the assets of just the first seven ‘big banks’: Deutsche Bank, HSBC,
BNP Paribas, Mitsubishi UFJ FG, Barclays, Royal Bank of Scotland, and JP Morgan Chase 13.
Banks’s special role
In this discourse, as actors and financial institutions, banks have particular importance.
Richard Werner (2012)14 clearly explains that their function cannot be easily replaced by
other financial players or markets. This has also empirically suggested, for instance by
Fama (1985), which shows that banks must have a kind of monopoly power compared to
other financial institutions, or by Ashcraft (2005), which shows that the closure of small
12
See also: http://finapps.forbes.com/finapps/jsp/finance/compinfo/CIAtAGlance.jsp?tkr=DB
See also: http://www.forbes.com/global2000/list/#p_1_s_d5_All%20industries_All%20countries_All%20states_
14
Please refer to the 2012 ESDN Workshop presentation of Richard A. Werner available at: http://www.sdnetwork.eu/?k=ESDN%20workshops&s=workshop%20documentation&year=2012
13
18
regional banks significantly hurts the local economy.
The main reason why banks have a special role in the financial system is to be found
especially in their action of money creation, which represents the 97% circa of all money
supply [please see Box 2 for official statements from Central Banks). Therefore, although
only 3% of money comes from central banks, the rest is all ‘banks’ money. Banks “are not
(just) financial intermediaries. They have a license to ‘print money’ by creating credit.
There is no such thing as a ‘bank loan’. Banks do not lend money, they create it” (Werner,
2012).
Box 2:
Bank Credit
Creation
admitted by
Central Banks
“The actual process of money creation takes place primarily in banks.”
(adapted from
Werner, 2012)
“Over time... Banknotes and commercial bank money became fully interchangeable
payment media that customers could use according to their needs” (ECB, 2000)
(Federal Reserve Bank of Chicago, 1961, p. 3)
“By far the largest role in creating broad money is played by the banking sector ...
When banks make loans they create additional deposits for those that have
borrowed.” (Bank of England, 2007)
“Contemporary monetary systems are based on the mutually reinforcing roles of
central bank money and commercial bank monies.” (BIS, 2003)
“The commercial banks can also create money themselves... in the eurosystem,
money is primarily created by the extension of credit.” (Bundesbank, 2009)
1.3. Links to the real economy
In 2011, Peetz and Genreith concluded their study by arguing that there is a close and
mutual relationship between the financial sector and the real economy: capital can
trigger economic growth. However, they then argue, “financial wealth cannot sustain
itself indefinitely without an adequate ‘real economy’ foundation”. As already noted,
Stiglitz clearly explains that an efficient financial sector is essential to a well-functioning
economy, but it should serve to improve the efficiency of the economy and to increase
its productivity: it should be a means to the economy and not an end in itself (2010).
Additionally, the Fung Institute15 asked an interesting question: can finance be a
perpetual profit machine that makes more money than the real sector? As explained in
their article, Sheng (2011), president of the Fung Institute, noted that “in the past 30
years, with growth in technology and financial innovation, finance morphed from being a
service agent to a self-serving principal that is larger than the real sector itself”. He
continues pointing out that “[t]he total size of financial assets has grown dramatically
from 108 per cent of global GDP in 1980 to over 400 per cent by 2009 [and if also] the
notional value of all derivative contracts were included, finance would be roughly 16
15
see also: http://www.fungglobalinstitute.org/publications/articles/putting-finance-to-work-for-the-real-economy-the-nextreform-16.html
19
times the size of the global real sector, as measured by GDP”. This trend has been called
‘Financialisation’ and it refers to “the increasing importance of financial markets,
financial motives, financial institutions, and financial elites in the operations of the
economy and its governing institutions, both at the national and international levels”
(Palley, 2007; Epstein, 2001).
It seems clear, therefore, that to really assess the financial sector in terms of sustainable
development, we need to consider what relations it has with the real economy.
The most important aspect one needs to understand is how the financial sector allocates
capital in the real economy. In September 2011, a report by ‘Forum for the Future’,
funded by Aviva Investors, outlined this concern: “Investment is about the future. How
the future turns out determines the returns on investments and the volatility of these
returns. But, in turn, the pattern of investments (where capital is allocated) itself helps to
determine the type of future we get.”
In order to understand how capital is allocated or invested, we need to consider
essentially what reasons determine the decisions over an investment, and therefore,
which investments are preferred. The word investment can have different facets, but
interestingly two of these can give us the idea of how the financial sector perspective is
actually very different from the real economy where governments, cities, households,
people are embedded. On the one hand, an investment can be understood as the action
or process of investing money for profit or material result. A second meaning sees an
investment as something that is worth buying because it may be profitable or useful in
the future. It seems that the first definition perfectly addresses the financial sector
perspective where a financial gain is pursued: in fact, in finance, an investment is a
monetary asset purchased with the idea that the asset will provide income in the future
or appreciate and be sold at a higher price16. On the other hand, the second side of the
definition addresses what usually is meant in the real economy where money is used ‘to
do something’, i.e. a city decides to invest building a road. In other words, the investment
here refers to the resulting production and consumption in the real economy.
16
http://www.investopedia.com/terms/i/investment.asp#ixzz2BjEkWhFL
20
2. Sustainable development and the financial sector
Chapter in brief:
 Sustainable development is development that “meets the needs of the present without
compromising the ability of future generations to meet their own needs”(WCED 1987).
 Sustainable development consists of six principles that need to be taken into account when discussing
the link to the financial market: 1) Balancing different policy dimensions; 2) Long timeframes and
intergenerational equity; 3) Ecosystems limits and planetary boundaries; 4) Equal opportunities and
access; 5) Inclusion and participation; 6) Governance for sustainable development
 Many differences exist between the sustainable development concept and the financial markets.
 The crucial difference between the two arenas is that while sustainable development has a
multidimensional and holistic perspective, in which a balance among environmental protection, social
equity and economic development is pursued, the financial sector seeks the one-dimensional goal of
the maximisation of financial profits.
 Among the interventions suggested, some are closer to the financial sector rationale: 1) Transaction
tax/Tobin tax; 2) Disclosure and Transparency; 3) Regulate speculation; 4) Bonuses regulation.
 Although the financial sector and sustainable development seem far apart from each other, a few
suggestions can be made to include the SD perspective into finance: (i) internalization of externalities
in the calculation of an investment (i.e. in a company’s present value); (ii) assigning a long-term
horizon to investments, also as a necessity for maintaining the prospect of safeguarding financial
capital for the future; (iii) progressive substitution of financial ratios with sustainability ratios; (iv) a
changing perspective on the connotation of financial profits.
2.1. Sustainable development principles
Sustainable
development
Six SD principles
Sustainable development has become a widely known and applied concept. The most
commonly used definition goes back to the Brundtland Commission of 1987 that defined
it as development that “meets the needs of the present without compromising the ability
of future generations to meet their own needs” (WCED 1987). Since a single and
reasonably short definition cannot provide sufficient guidance for implementation, a set
of normative principles of sustainable development is often used in addition to the
Brundtland definition. The Rio Declaration, itself consisting of 27 principles, and Agenda
21, the action plan to implement Rio, have often been used as a source and as a basis for
the formulation of a process-related set of sustainable development principles:
1.
2.
3.
4.
5.
Balancing different policy dimensions;
Long timeframes and intergenerational equity;
Environment preservation, limits to growth, and planetary boundaries;
Equal opportunities, access, and intra-generational equity;
Inclusion and participation;
21
6. Governance for sustainable development.
1. Balancing
different policy
dimensions
The first of these criteria is probably the most encompassing one because it comprises
many aspects of sustainable development, and gives also an idea of how to
operationalize the concept. Sustainable development is generally understood as a
development that aims to balance different policy dimensions - mainly economic
prosperity, environmental protection, and social justice. Balancing sustainable
development dimensions means that a ‘holistic’ point of view should be followed and a
balanced consideration of economic, environmental, and social aspects should be
pursued in the process of development (Forum for the Future, 2004).
2. Long
timeframes and
intergenerational
equity
A second crucial issue is the idea of taking into account long timeframes. In fact,
sustainable development calls for the necessity of a so-called inter-generational equity,
which refers to the equality of distribution of resources and risks between the current
and future generations. Principle 3 of the Rio Declaration states that “[t]he right to
development must be fulfilled so as to equitably meet developmental and environmental
needs of present and future generations” – in this we can derive the principle of intergenerational equity.
3. Environment
preservation,
limits to growth
and planetary
boundaries
Principle 3 of the Rio Declaration, the environment preservation aspect, is very central in
the sustainable development discourse. In fact, whilst sustainable development
recognises that the Earth has limits and planetary boundaries should be considered
(Rockström et al., 2009), it also acknowledges that the economy is embedded in the Earth
system, relying on its ecosystems to function, and in return producing waste, consuming
resources, and impacting ecosystems back. The consequence of this line of thinking is
that the economy also needs to recognise limits to growth (i.e. Meadows et al., 1972).
Ecosystems conservation and enhancement is, therefore, a key aspect of sustainable
development. Consideration of risks is also crucial, and a guiding principle in sustainable
development. This consideration can be found in the so-called precautionary principle,
as defined in the Rio Declaration: “where there are threats of serious or irreversible
damage, lack of full scientific certainty shall not be used as a reason for postponing costeffective measures to prevent environmental degradation” (UNCED, 1992, Principle 15) 17.
4. Equal
opportunities,
access and intragenerational
equity
As seen, sustainable development is not only about intergenerational equity, but it is also
very much interested in intra-generational equity, which considers the fairness of
distribution of resources and risks within the current generation. This fourth criterion
calls for equal opportunities and same possibilities in terms of access to resources as
important aspect of sustainable development. In sustainable development, a number of
terms and concepts are therefore crucial, namely: distribution and re-distribution, wellbeing, fighting poverty, equal consideration of societies and humans around the world,
an urge for democracy, and education propagation.
17
http://www.unep.org/Documents.Multilingual/Default.asp?documentid=78&articleid=1163
22
5. Inclusion and
participation
As fifth criterion, essentially retrieved from the 10th Rio Declaration’s Principle,
sustainable development is very much based on inclusion and participation. Sustainable
development “issues are best handled with participation of all concerned citizens, at the
relevant level. At the national level, each individual shall have appropriate access to
information (…) and the opportunity to participate in decision-making processes. States
shall facilitate and encourage public awareness and participation by making information
widely available. Effective access to judicial and administrative proceedings, including
redress and remedy, shall be provided” (UNCED, 1992).
6. Governance
for sustainable
development
As addressed by several academics18 and international organisations19, a final key criterion
that has acquired importance over time is the principle of ‘governance for sustainable
development’. The link between governance and sustainable development is
fundamental and was already addressed by the Brundtland Commission in 1987.
Governance mechanisms are generally crucial for achieving sustainable development.
The goal of sustainable development involves a reform agenda that includes reforms in
cross-sectoral governance structures and processes, vertical policy coordination,
enhanced participation in policy-making, increased reflexivity (e.g. evidence-based
policy-making), and long-term time frames20. The first document to frame sustainable
development as a governance reform agenda was Agenda 21 21. The governance aspects
of the action plan were reiterated and complemented at the UN World Summit in
Johannesburg 2002 (Rio +10). The World Summit Report pointed out that “good
governance is essential for sustainable development”22.
This concept is developed from the notion of ‘good governance’, which is a specifically
normative idea that prescribes certain steering procedures and institutions – based on
principles, values and norms, i.e. participation, transparency, rule of law, etc. – that
should be adopted to achieve the preferred outcomes. The origin of the concept of good
governance is associated with international organisations23 such as the World Bank and
the OECD in the context of development policy. As well defined by the UN Economic and
Social Commission for Asia and the Pacific (UNESCAP) 24, good governance has eight key
features: 1) participatory; 2) consensus oriented; 3) accountable; 4) transparent; 5)
responsive; 6) effective and efficient; 7) equitable and inclusive; and, 8) follows the rule
of law. To show how good governance and sustainable development are interlinked in a
European policy document, the renewed European Union Sustainable Development
Strategy (EU SDS) of 2006 is a good example, as it addresses good governance in various
18
See also: Jordan, 2008; Baker and Eckerberg, 2008; Steurer, 2007; Lafferty, 2004.
UN Johannesburg Plan of Implementation, 2002; OECD, 2002.
20
OECD, Governance for Sustainable Development, OECD Paris, 2002; Lafferty, W.M., ‘Adapting Governance Practice to the
Goals of Sustainable Development’, 2002, http://webs.uvigo.es/dialogos/biblioteca/goals.pdf.
21
UNCED, Agenda 21, United Nations New York, 1992.
22
United Nations, Report of the World Summit on Sustainable Development, United Nations New York, 2002.
23
In the European context, the EU has addressed good governance in its White Paper on European Governance (2001).
24
http://www.unescap.org/pdd/prs/ProjectActivities/Ongoing/gg/governance.asp
19
23
policy-guiding principles. To achieve its objectives, the EU SDS sets out an approach to
better policy-making based on better regulation and integration of sustainable
development criteria into policy-making at all government levels.
2.2. The main differences
When it comes to considering the main differences between sustainable development
and the financial markets, many seem to be outstanding, and they are sometimes even
self-evident. Although there may be others, especially in categories that are not
immediately related to finance (i.e. democracy), we will analyse in detail those
differences that seem to us most prominent, and most related to the six sustainable
development principles outlined in the previous chapter.
(1) Balancing SD
dimensions
vs. onedimensional goal
While sustainable development aims to increase the opportunities for all societies,
present and future, the financial sector mainly strives for the short-term maximization of
financial profits and the return on investment. Understood as the net profit over the
investment made, the return on investment is the main concern for financial markets,
which explains why the financial sector has as a largely one-dimensional goal that
privileges only the economic dimension.
(2) Long
timeframes and
intergenerational
equity vs. shortterm profits
Secondly, a very self-evident difference concerns timeframes. The pursuit of short-term
profits, or the search for immediate gain that is as close as possible to the present,
largely defies the ideas of considering the long-term or caring for future generations,
which are addressed as inter-generational equity in the sustainable development
discourse.
According to Lydenberg (2007), there is a widespread debate within the financial and
business community - including the CFA Institute, the Business Roundtable, the
Conference Board, the United Nations, the World Economic Forum, and the Aspen
Institute. Short-termism is claimed to have a number of detrimental effects on the
financial market itself, the real economy, as well as environment and society overall.
Among the dangers for financial as well as corporate communities are (Tonello, 2006):

At the macro-economic level: short-term visions cause market volatility and the
instability of financial institutions.

At the micro-economic level: short-term investment strategies drive short-term
thinking in business
o
o
undermining management continuity and exposing a public company to the
risk of losing sight of its strategic business model, compromising its
competitiveness.
pressure to meet short-term numbers may induce senior managers to
externalize a number of business costs (i.e., the cost of a state-of-the-art
pollution system), often to the detriment of the environment and future
generations.
24
One of the main reasons for short-termism to persist as a stable factor in the system (as
highlighted by the box-text below), is that while investors can maximise financial return
and their actions may have wider impacts on individual companies and the system as a
whole, they may not directly be exposed to the consequences.
Box 3:
Examples of the
consequences of
short-termism on
the financial
market
(adapted from
Forum for the
future, 2011)
 Investors in fossil fuel companies can gain attractive short-term returns from
high oil prices. However, carbon emissions will have an impact on the long-term
health of the economy as well as the environment, and the value of investors’
portfolios could suffer unless they shift out of these carbon-intensive
companies and into alternatives in a managed way.
 In the run-up to the financial crisis, many financial institutions recognised that
there were risks in the complex financial products they were selling, but they
were competing with peers to deliver superior short-term returns, and
underestimated or dismissed the longer-term impacts.
 Private investment in unsustainable ‘drag’ fishing technology drove the cod
population in Newfoundland, Canada to near-extinction in the 1990s and
resulted in permanent damage to local communities with the loss of 40,000
jobs. A longer-term perspective would have yielded greater returns for more
investors over a longer period of time, and would have avoided these
catastrophic ecosystem and community impacts.
Discounting
Another important aspect to take into account when considering timeframes is the role
of the practice called ‘discounting’ that takes an important part in the financial sector.
What the financial sector always provides is a so-called present value of investments,
using discounting techniques that provide a value in the present of the gains that will
occur in the future. As argued by Schmidheiny and Zorraquin (1996), financial markets
discount the future routinely and heavily, while sustainable development is concerned
with the importance of the future. Although we are talking about discounting financial
flows, it is also true that these financial flows intervene on the real economy, and,
furthermore, no consideration is taken over future capital of future generations, but
merely individual gain.
(3) Environment
preservation,
limits to growth
and planetary
boundaries
For what concerns the environmental pillar of sustainable development, there is no
incentive for the financial sector to take this into account for two main reasons. First, as
we just argued, the financial sector has a one-dimensional goal: it is only interested in the
maximisation of financial profits. This can be extended into the argument that the
financial sector does not have a real concern in the quality of its investments as long as
they are profitable investments. This means that there is no ethical consideration of
investments, or no consideration of ‘bad’ externalities in the calculation of profits.
Whether a financial investment is made over a polluting company or a non-polluting
company is no concern by the logic of the financial sector. Furthermore, the financial
investment will probably be made in the polluting one since it will perhaps provide
higher returns because of the fewer costs it has in comparison with the non-polluting
25
company, which is likely spending more to take care of the environment.
Another interesting point can be made here in terms of the consideration of risks. For
instance, Schmidheiny and Zorraquin (1996) assumed that accounting and reporting
systems do not adequately convey potential environmental risks or opportunities. If this
holds true, therefore, financial markets are compelled to make decisions based on biased
information. In the sustainable development discourse, the precautionary principle had
a crucial importance in our analysis. If it is true that the financial sector does not take
into consideration the environmental dimension, then environmental risks can be
created when investment decisions are taken. These risks could easily assume a real
connotation that, starting from a ‘bad’ investment, has the potential of affecting
thousands or millions of people around the world.
(4) Equal
opportunities,
access and intragenerational
equity
If we look at the precautionary principle from a broader perspective and, hence, we
consider the precautionary principle as a guiding attitude for societies, we see again a
fundamental difference in the way financial markets deal with risk. Financial markets are
supposed to help to manage risks and deal with uncertainty, and this is an extremely
important support that financial markets give to the real economy, ideally managing
risks, avoiding high losses, and allowing smoother operations. However, in finance, it is
also true that higher risks leads to higher profits, which could mean that if one is very
attracted by financial profits and not averse to risk, the possibility to lose the investment
for a larger return will be accepted.
This concerns very much the so-called ‘social’ dimension of sustainable development,
where intra-generational equity, equal opportunities, access to resources, well-being,
and distribution are key aspects of the discourse. Considering financial risks in a
‘precautionary’ mode could mean that the effects on the real economy and society are
taken into account; for instance, in terms of job loss, company closures or systemic
problems to the whole economy. What role could the ‘precautionary principle’ play in
the financial markets to ‘safeguard’ the society, the environment, and the economy? Is
there a chance to develop a “Precautionary Financial Principle”? Interestingly again, the
one-dimensional logic of the financial sector poses serious concerns over the possibility
of considering a social dimension in its undertakings.
(5) Inclusion and
participation
With regards to the ‘inclusion and participation’ principle that we underpinned for
sustainable development, the first thing that can be noted when looking at differences is
the complexity of the financial sector. This is a very technical sector where a high degree
of specialty and financial knowledge is needed. Capacities for managing stress, the
quantity and speed of information that needs to be taken into account, and the ability of
making investment decisions in a very short time and in a highly competitive
environment are generally recognised as distinctive requirements for working in the
financial sector. Furthermore, the high number of financial instruments that are
constructed and the highly complex mathematical foundations of them are probably
another distinctive aspect to be considered. All of these characteristics have, on the
26
other hand, another connotation: because of this complexity, people feel generally
excluded from the financial world and have difficulties understanding it. This could
somehow go against and differ from what we defined as the criterion of ‘inclusion and
participation’ in the sense that appropriate access to information and opportunities to
participate in decision-making processes, as outlined in the 10th principle of the Rio
Declaration, are in reality made to be very difficult, or are practically absent in the
operation of the financial markets.
(6) Governance
for sustainable
development
Finally, in terms of governance for sustainable development, the financial sector in many
ways defies the features of what has been portrayed as good governance. We touched
upon the participatory and the inclusivity aspects already, and this goes largely against
the logic of the financial sector. Being effective and efficient is most probably the one
characteristic that is more addressed by the financial sector, in the sense that the
financial sector should serve the economy by increasing its efficiency and its productivity
(hence its effectiveness). However, what is described in the ‘good governance’
framework as “effective and efficient” also covers the sustainable use of natural
resources and the protection of the environment, and is a slightly different concept, in
which processes and institutions produce results that meet the needs of society while
making the best use of resources at their disposal.
Finally, transparency, accountability, and following the rule of law are very much linked,
especially considering that accountability cannot be enforced without transparency and
the rule of law. Transparency also means that information is freely available and directly
accessible to those who will be affected by such decisions and their enforcement, and
that enough information is provided in a way that is easily understandable. This means,
in order to bring the financial sector more in line with good governance procedures, it is
necessary that it is transparent to the public and accountable to those who will be
affected by its decisions or actions. This is a strong call for societies to decide how much
and in what way they are affected by the financial sector, which also means that
whenever strong impacts of the financial sector on the real economy, the environment,
and/or society are expected, strong regulations, supervision, control, and public debate
should hold a key role.
Table 1:
Framework for
comparing
Sustainable
Development
and the financial
sector
(Our analysis)
Sustainable development
Financial sector
Balancing SD dimensions: environment
preservation, social equity, economic
development
Long timeframes and intergenerational
equity
Environment preservation, limits to
growth, and planetary boundaries
Equal opportunities, access, and intragenerational equity
Inclusion and participation
One-dimensional logic; maximisation of
profits and return on investment
Governance for SD
Short-term perspective; discounting;
present value calculation
Little to no consideration of environmental
effects
Little to no consideration of social effects
Highly complex; not inclusive, nor open to
participation
Efficiency oriented; shortage of
transparency and accountability
27
2.3. Regulations and interventions
Although the financial markets rationale and the sustainable development discourse
seem far apart from each other, we provide an overview of possible interventions on the
financial sector that could help in reducing the distances. In terms of regulations, among
the interventions that could be implemented, we firstly present those that seem closer
to the financial sector and that are already considered at different levels (i.e. EU level): 1)
Transaction tax/Tobin tax; 2) Disclosure and Transparency; 3) Regulate speculation; 4)
Bonuses regulation. Secondly, we will portray a number of different interventions from a
sustainable development perspective that would enable a stronger consideration of the
sustainable development criteria in the financial sector.
Regulations for the financial sector
1) Transaction tax/Tobin tax
A Eurozone
Financial
Transaction Tax
(FTT)
Currently, European Member States are discussing a way to introduce a transaction tax,
as confirmed on 9 October 2012 by the EU Commissioner for taxation. In the media this is
usually addressed as Tobin Tax, which comes from the proposal made by Prof. James
Tobin for an international tax on foreign exchange transactions with the purpose of
“penalize short-horizon round trips” (Tobin, 1996) 25. As he explained clearly to “Der
Spiegel” in 200126, his intention was to limit exchange rate fluctuations with a simple
idea:
“on every exchange of one currency for another a small tax would become due,
let's say one half of a percent of the transaction. That would scare speculators
away. For there are many investors who put their money into currencies for the
very short term. If this money is suddenly withdrawn, the countries have to raise
interest rates drastically so that the currency remains attractive. High interest
rates often are disastrous for the domestic economy, as was demonstrated by
the crises in Mexico, Southeast Asia and Russia during the nineties. My tax
would restore some room for manoeuvre to small countries' central banks as
against the tyranny of the financial markets”. (Tobin, 2001)
Similar to a Tobin-tax, on 28 September 2011, the European Commission adopted a
proposal for a Council Directive on a common system of financial transaction tax (FTT)27,
aiming at:
 harmonising legislation concerning indirect taxation on financial transactions,
which is needed to ensure the proper functioning of the internal market for
transactions in financial instruments and to avoid distortion of competition
between financial instruments, actors, and market places across the European
25
ul Haq, M., I. Kaul and I. Grunberg. 1996 The Tobin Tax: Coping with Financial Volatility. Oxford University Press: New York,
Oxford.
26
Der Spiegel. 2001. “They Are Misusing My Name". September 2, 2001 [English translation by Yale Department of Economics:
http://www.econ.yale.edu/news/tobin/jt_01-09-02_ds_misusing-name.htm]
27
see also: http://ec.europa.eu/taxation_customs/resources/documents/taxation/com_2012_631_en.pdf
28


Union, and at the same time;
ensuring that financial institutions make a fair and substantial contribution to
covering the costs of the recent crisis and creating a level playing field with other
sectors from a taxation point of view, and
creating appropriate disincentives for transactions that do not enhance the
efficiency of financial markets, thereby complementing regulatory measures to
avoid future crises.
Although diverse opinions still persist in the EU, ten Member States (Belgium, Germany,
Greece, Spain, France, Italy, Austria, Portugal, Slovenia, and Slovakia) have addressed
formal requests to the Commission to establish an enhanced cooperation for a common
system of FTT and that the Commission was asked to submit a proposal to the Council on
that manner. They specified that the scope and objectives should be based on the
Commission's proposal of September 2011 for a Council Directive on a common system
of financial transaction tax.
2) Disclosure and Transparency
Disclosure,
transparency,
stronger
supervision
With more open information and more appropriate reporting systems, a stronger and
more effective supervision could help to avoid negative effects coming from the financial
sector. Disclosure and transparency would, therefore, serve to open up secrecy and
make information about financial transactions more accessible for the authorities and
the public. A concrete example is the European Market Infrastructure Regulation (EMIR)
proposal that tries to ensure that the details of any over-the-counter (OTC) derivative
contract that have been concluded and any modification, or termination of the contract
is reported to a trade repository. A trade repository would then maintain it for at least
ten years following the termination of the relevant contracts, and would make the
necessary information available to relevant supervisory authorities (EU,
COM(2010)484/5).
3) ‘Regulate’ speculation
Ban big speculators
28
Speculation is intended as the taking of relatively high risks and the acceptance of the
possibility of losses in the hope of making large gains 28. Many say that speculation is a
successful instrument for improving efficiency of markets because it allows prices to
adapt much more quickly than they would through short selling. What is not ‘good’ is not
speculation as such, but the big speculators who are able, for instance, to use hedging
instruments to make big profit and move enormous amounts of money with the peril of
causing large systemic losses and cascade effects. In this sense, a good option could be to
‘regulate’ speculation through ‘licensing’ participants in the markets, and somehow
banning those who are too big and able to pose such systemic problems.
http://glossary.reuters.com/index.php/Speculation
29
4) Bonuses regulation
Regulate bonuses
to tackle excessive
and imprudent risktaking
When we talk about bonuses, we usually refer to a compensation system as a provision
of financial incentives to work and reach results. Nowadays, “the purpose of bonuses in
the financial world seems to have shifted. Instead of being offered as a reward for a job
well done, they now appear to be handed out simply because the job was done” (De
Cremer29). Also, as outlined in the Directive 2010/76/EU, what is evident is that the
inappropriate remuneration structures of some financial institutions have been a
contributory factor of excessive and imprudent risk-taking in the banking sector, which
partially led to the failure of individual financial institutions, and then to systemic
problems. It is especially said that remuneration policies that give incentives to take risks
(…) can undermine sound and effective risk management and exacerbate excessive risktaking behaviour. The mentioned EU directive30 2010/76/EU was therefore put in place to
regulate this aspect of the financial sector, where a major problem was detected in the
wrong incentives that led to excessive risk-taking, which at the end impacted the whole
real economy.
Examples from recent developments in the USA
Recent regulation
of the financial
sector in the USA
Table 2: Dodd-Frank
Wall Street Reform
and Consumer
Protection Act31
On July 12, 2010 president Obama in the USA signed a new regulation for the financial
sector with four main objectives32: (1) To promote the financial stability of the United
States by improving accountability and transparency in the financial system; (2) to end
‘too big to fail'; (3) to protect the US taxpayers by ending bailouts; (4) to protect
consumers from abusive financial services practices. In Table 2 below, we summarise the
main highlights as reported by the US Senate Committee on Banking, Housing & Urban
Affairs.
The Dodd-Frank Wall Street Reform and Consumer Protection Act
1) Consumer
Protections with
Authority and
Independence
2) Ends Too Big to Fail
Bailouts
3) Advance Warning
System
4) Transparency &
Accountability for
Exotic Instruments
5) Executive
Creates a new, independent watchdog with the authority to ensure that
American consumers get the clear, accurate information they need to
shop for other financial products, and to protect them from hidden fees,
abusive terms, and deceptive practices.
Ends the possibility that taxpayers will be asked to write a check to bail out
financial firms that threaten the economy.
Creates a council to identify and address systemic risks posed by large,
complex companies, products, and activities before they threaten the
stability of the economy.
Eliminates loopholes that allow risky and abusive practices to go on
unnoticed and unregulated - including loopholes for over-the-counter
derivatives, asset-backed securities, hedge funds, mortgage brokers, and
payday lenders.
Provides shareholders with a say on pay, and corporate affairs with a non-
29
see also: http://bsr.london.edu/lbs-article/583/index.html
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2010:329:0003:01:EN:HTML.
See also: http://ec.europa.eu/internal_market/bank/regcapital/legislation_in_force_en.htm#maincontentSec5
31
http://banking.senate.gov/public/_files/070110_Dodd_Frank_Wall_Street_Reform_comprehensive_summary_Final.pdf
32
http://www.gpo.gov/fdsys/pkg/PLAW-111publ203/html/PLAW-111publ203.htm
30
30
Compensation and
Corporate Governance
6) Protects Investors
7) Enforces Regulations
on the Books
binding vote on executive compensation and golden parachutes.
Provides tough new rules for transparency and accountability for credit
rating agencies to protect investors and businesses.
Strengthens oversight and empowers regulators to aggressively pursue
financial fraud, conflicts of interest, and manipulation of the system that
benefits special interests at the expense of American families and
businesses.
Interventions from a sustainable development perspective
The four interventions outlined above all aim to restrict the financial sector with legal,
economic, and/or financial tools. However, it seems that more could be done, especially
when taking into account the six SD principles previously defined. We outline four
possible interventions: (i) internalization of externalities in the calculation of an
investment (i.e. in a company’s present value); (ii) assigning a long-term horizon to
investments, also as a necessity for maintaining the prospect of safeguarding financial
capital for the future; (iii) progressive substitution of financial ratios with sustainability
ratios; (iv) a changing perspective on the connotation of financial profits.
(i) Internalization of
externalities
Internalization of externalities in investment decisions could potentially contain an
answer to many of the sustainable development concerns around financial markets.
Environmental, social, and economic threats could be quantitatively assessed and taken
into account for financial transactions. This would enable the consideration of balancing
different policy dimensions.
(ii) A long-term
horizon
Assigning a long-term horizon to investments, also as a necessity for maintaining the
prospect of safeguarding financial capital for the future, might also be a possibility. For
instance, it could be suggested that a certain percentage of investments need to be
‘saved’ for the future, or that a ‘precautionary financial principle’ is included in
investment decisions in order to avoid the creation of too high risks that have the
potential of posing systemic risks to the real economy.
(iii) Sustainability
ratios
The third intervention could be to progressively substitute the base for investment
decisions and policies from financial ratios to sustainability ratios. The downturn for this
suggestion is unfortunately very visible: the problem here is to understand whether
sustainable development could be achieved without having to revise current norms and
values (or the current worldview in which modern society is dominated by economic
materialism) (Jeucken, 2001).
(iv) A changing
perspective
Related to the previous intervention, a fourth and last suggestion is probably the most
controversial, but perhaps the most effective in terms of prospects for genuine change.
Among different instances, the experience of the so-called "Common Welfare Economy"
(Felber, 2012) shows the basic elements of an alternative economic framework, where,
among others, economic success is no longer measured with monetary indicators, such
as financial profit. In this case, economic success is defined by providing and/or
31
improving basic needs, quality of life, communal values, etc. In this case, market values
and social values are no longer contrasting.
2.4. Potentials to enable sustainable development financing
In September 2011, Forum For the Future completed a report in which they showed
investors how they can help create a resilient, stable, and sustainable economy by
investing wisely and using their power to shape the development of capital markets.
ESDN case study
on Sustainable
Investment
An important part of a more sustainable financial sector, with high potential for enabling
sustainable development financing, can be played by so-called Socially Responsible
Investments (SRIs). In this regard, the ESDN Office has prepared an ESDN Case Study
entitled “Sustainable investment: options for a contribution to a more sustainable
financial sector” (Endl, 2012, ESDN Case Study No 11), in which we call for a richer
overview on this topic. SRI is the most applied and well-known term that represents
inter-alia a larger array of instruments all connected with sustainable, green, or ethical
investing. The term “socially responsible investment” (SRI) became the most widespread,
and may actually be used interchangeably with the term sustainable investment since it
also relates to practices that are central to the concept of sustainable development (i.e.
considering economic, social, environmental aspects). Therefore, we will use the term
SRIs to comprehend this larger picture ,and will use the case study as the main source for
this section.
Socially
Responsible
Investments
(SRIs)
SRIs have been created to describe investment strategies that seek to consider both
profit and societal well-being. Socially responsible or sustainable investors encourage
corporate practices that promote issues such as environmental stewardship, consumer
protection, human rights, quality of labour and jobs, as well as sustainable use of natural
resources. Today, SRI is an established industry offering a variety of specialised and
standardised products to both retail33 and institutional investors34.
The classification of different investment strategies actually undertaken on the financial
capital market is also complex. Bridges Ventures (2012) tries to capture the breadth of
these different investment strategies as displayed in Table 3 (below). The term impact
investments covers investments made into companies, organizations, and funds with the
intention of generating social and environmental impact alongside a financial return
(Bridge Ventures, 2012).
33
34
A retail investor is an individual investor possessing shares of a given security
An institutional investor is an investor such as a bank, insurance company, retirement fund, hedge fund, or mutual fund, that
is financially sophisticated and makes large investments
32
Figure 4:
Different
investment
strategies for SRI
(Bridges
Ventures, 2012)
In this regard, the European Sustainable Investment Forum (EUROSIF, 2012) offers a
comprehensive classification scheme that covers the wide range of SRIs and other
responsible investment strategies. EUROSIF developed a framework that identifies seven
distinct processes, referred to as strategies, displayed in Table 4 below. In fact, these
seven processes represent the strategies used by asset managers that incorporate
sustainable development into their investment decisions or take into account ESG criteria
in various shapes and forms.
Table 3:
Overview of SRI
investment
strategies
(EUROSIF, 2012)
Strategy
1. Sustainability
Themed Investment
2. Best-in-Class
Investment Selection
3. Norms-based
Screening
4. Exclusion of
Holdings from
Investment Universe
5. Integration of ESG
Factors in Financial
Analysis
6. Engagement and
Voting on
Sustainability Matters
7. Impact Investment
Definition
Investment in themes or assets linked to the development of sustainability.
Thematic funds focus on specific or multiple issues related to ESG.
Approach where leading or best-performing investments within a universe,
category, or class are selected or weighted based on ESG criteria.
Screening of investments according to their compliance with international
standards and norms
An approach that excludes specific investments or classes of investment from
the investible universe, such as companies, sectors, or countries.
The explicit inclusion by asset managers of ESG risks and opportunities into
traditional financial analysis and investment decisions based on a systematic
process and appropriate research sources.
Engagement activities and active ownership through voting of shares and
engagement with companies on ESG matters. This is a long-term process,
seeking to influence behaviour or increase disclosure.
Impact investments are investments made into companies, organizations, and
funds with the intention to generate social and environmental impact alongside
a financial return. Impact investments can be made in both emerging and
developed markets, and target a range of returns from below market-to-market
rate, depending upon the circumstances.
33
Performance and
trends of SRIs
Most common
SD related
themes for
investments
Table 4:
Aggregated
market growth (€
billions) of 14
European
countries
(EUROSIF, 2012)
Future
development
trends
According to the Global Alliance for Banking on Values (GABV, 2012), the concept of
sustainable finance and investment continues to grow, especially in the wake of one of
the most devastating financial crises in history. This includes responsibility from the
corporate side (CSR) as well as the investor side (SRI) of the capital markets. In this
respect, some of the key findings on a comparison of sustainable banks and Global
Systemically Important Financial Institutes (GSIFIs)35by GABV (2012) showed that
sustainable banks have:

much higher levels of equity to total assets, with slightly higher levels of BIS 1
capital ratios (especially in recent years) than GSIFIs.

generally better or comparable Return on Assets and Returns on Equity over the
time period covered. The returns of Sustainable Banks are also less volatile than
those of GSIFIs.

significantly higher growth in loans and deposits leading to higher growth in
assets and income than GSIFIs.
Among the most common sustainable development related themes for investment is
clean tech, with investors making allocations to, for example, renewable energy,
resource and energy efficiency, and waste technology. On the social side, microfinance
remains popular with PRI signatories as well as other sectors such as global health,
education, and social infrastructure. Regarding future trends of investment, while
sustainable forestry has traditionally been an important asset class for many asset
owners, sustainable agriculture is also gaining increasing attention 36 (UNEP, 2012).
Investment strategy
SustainabilityThemed
Best in Class/Positive Screening
Norms-based screening
Exclusions
Engagement/Voting
Integration
009
€ 25,361
€ 132,956
€988,76
€ 1,749,42
€ 1,668,473
€ 2,810,506
201
€ 48,090
€ 23,206
€ 2,346,308
€ 3,829,287
€ 1950,406
€ 3,204,107
Growth (CAGR)
37.7%
45.9%
54.0%
47.9%
8.1%
6.8%
Concerning future development trends for SRIs, EUROSIF (2012) argued that continued
and increasing focus on investors by national and EU legislators through regulations such
as the European Social Entrepreneurship Funds Framework will be beneficial for the
increase in SRIs, which according to the study, will be the second most important factor
35
A study commissioned by GABV and funded by the Rockefeller Foundation and GABV compared the performance of 17
values-based banks with 29 of the world's largest and most influential banks including Bank of America, JP Morgan, Barclays,
Citicorp and Deutsche Bank.
36
This trend concerns only signatories of the United Nations-backed Principles for Responsible Investment (PRI)
34
for growth in SRIs. Further growth for SRIs will be expected also due to other factors such
as: 1) demand from institutional investors; 2) international initiatives; 3) external
pressure; and, 4) demand from retail investors.
Banks
developments
megatrends
In this discourse, banks are developing differently from the past and are in search of new
business models. As pointed out by Volker Abel37, sustainability represents one of six
megatrends38 that need to be taken into consideration, as it is impacting banks business
models (please see figure below).
Figure 5:
Six megatrends
impacting banks
business models
(adapted from
Volker Abel)
In fact, in search of generating value, many banks are reshaping their business models
towards more sustainable business practices and, therefore, distinguishing between two
dimensions: (i) Financial sustainability (Solid financial performance with risks well under
control); and, (ii) Social/ ecological sustainability (Fair treatment of environment, all
members of society and all generations).
As the following figure shows, it is important to consider that, although the range of
possibilities to incorporate sustainability aspects into core bank business is wide, some
concepts are already being applied successfully.
37
Please refer to the 2012 ESDN Workshop presentation of Volker Abel available at: http://www.sdnetwork.eu/?k=ESDN%20workshops&s=workshop%20documentation&year=2012
38
A megatrend is (1) valid for a period of minimum two decades, (2) observable in the relevant spheres of life, (3) an
international phenomenon and (4) stable, able to survive setbacks
35
Figure 6:
Examples of
approaches of
social banking in
the German
banking industry
(adapted from
Volker Abel)
Best practice of financial institutions and products in Europe
The financial market covers a myriad of different assets (such as investment funds,
shares, bank deposits, pension funds, micro-credits etc) managed by different
institutions and actors (e.g. asset managers, pension funds, insurance companies,
development finance institutions etc.), for which various kinds of guidelines or
frameworks of SRI exist. In this part, we will reflect upon some best practice examples of
assets and institutions in Europe in the area of SRI.39
Obviam independent
investment
advisor for
impact investing
Obviam is an independent investment advisor that offers a broad range of investors
access to impact investing in emerging and frontier markets. Obviam is a fund-of-funds
manager: it invests in private equity fund managers operating on the ground in
developing countries.
Currently, Obviam's senior partners have invested over US $400 million in more than 70
funds and 300 underlying small and medium sized enterprises (SMEs) on behalf of the
Swiss Confederation since 1999. The Swiss Investment Fund for Emerging Markets
(SIFEM; i.e. the Development Finance Institution of the Swiss Confederation, and
Obviam’s largest fund in management) tends to favour investment in SMEs as it believes
this is where it can best support developing countries in terms of job creation, private
sector development, and improving economic revenues. In this regard, all of Obviam’s
investments for SIFEM follow four critical development investment tenets:
39

Subsidiarity: providing long-term financing in markets where it is scarce.

Leverage: mobilising third-party capital by providing a ‘signalling’ effect to the
market through investments.

Additionality: taking an active approach to investing, Obviam aims to assist
The best case practices have been taken from reports by EUROSIF and PRI
36
private equity funds it invests in (especially new investment teams and first-time
funds) to develop and improve according to international best practice.

European Social
Entrepreneurship
Funds
Framework
Sustainability: ensuring investments made are both financially viable and follow
ESG best practices.
In December 2011, the European Commission set out a proposal (European Commission,
2011) introducing a new EU-wide fund structure (European Social Entrepreneurship Fund
– EuSEF) to provide support to the market for social businesses by improving the
effectiveness of fundraising by investment funds that target these businesses. Essentially,
this proposal aims to create a trusted EU label for Social Entrepreneurship funds, which
would increase confidence in this market and overcome some of the barriers hindering
its growth, in particular the uneven distribution of capital available for social investment
across Europe.
EuSEFs are pooled funds that invest at least 70% of their capital in qualifying
investments. The range of qualifying investments, including equity and debt instruments
for instance, is related to eligible "social business" undertakings. These are defined as
undertakings whose primary objective is the achievement of a positive social impact,
rather than financial gain to shareholders or other stakeholders. They include
undertakings that provide social services or goods to vulnerable or marginalized persons,
and undertakings that employ a method of production of goods or services that
embodies a social objective. An example relating to the first category would be access to
housing or healthcare, while an example of the second one would be professional
integration for disadvantaged segments of the population.
The Norwegian
Government
Pension Fund Global
One of the best practice examples for SRI, and often called the ‘Gold standard’ in
institutional responsible investing, is the Norwegian Government Pension Fund – Global.
However, the Norwegian fund is not very different from many other large institutional
investors in their responsible investing process - the differentiator is transparency. For
many years, the Norwegian Ministry of Finance, the Ethical Council, and the Fund itself
have been transparent about their screening process and their expectations of
companies, and have been thorough in justifying their decisions. This quality of process
and transparency has led many other investors to emulate their decisions.
37
Two examples in the financial world towards sustainable development
Triodos Bank is one of the world's leading sustainable banks with a mission to make
money work for positive social, environmental and cultural change:
1. Help create a society that protects and promotes the quality of life of all its
members
2. Enable individuals, organisations and businesses to use their money in ways that
benefit people and the environment, and promote sustainable development
3. Provide our customers with innovative financial products and high quality service
Triodos Bank’s approach is based on:
1. A sustainable business model: the bank only work in the real economy without
investing in complex financial instruments (with the promise of high profits that
bring greater risk), in order to remain solid and stable;
2. Positively 100% sustainable: only lend money to people and organisations working
to make the world a better place, actively seeking out and promoting sustainable,
entrepreneurial businesses driven by values and ideas;
3. Total transparency: publish details of every single organisation Triodos lends to,
with the intention of making possible to savers and investors to see exactly how
Triodos is using their money.
(Triodos Bank, 2012) 40
SAM is a global investment boutique focused exclusively on Sustainability Investing.
The firm’s offering comprises asset management, indexes and clean tech private
equity.
SAM partners with Dow Jones Indexes in the publication and development of the Dow
Jones Sustainability Indexes (DJSI).
Founded in 1995, SAM today has more than 100 employees and belongs to Robeco, a
subsidiary of the Dutch Rabobank Group.
SAM’s mission is to drive sustainability thinking using financial markets as the most
powerful transmission mechanism to promote sustainable business practices.
SAM uses an integrated sustainability research approach that integrates ESG factors
into the financial analysis of companies. Their key idea is to research ESG factors that
can impact the long term business success of a company. SAM’s research approach
wants to be objective and standardized and covers over 3000 large and mid-caps
globally.
(SAM group, 2012) 41
40
th
Please refer also to the presentation by James Vaccaro at the 8 ESDN workshop, available at: http://www.sdnetwork.eu/?k=ESDN%20workshops&s=workshop%20documentation&year=2012
41
th
Please refer also to the presentation by Guido Giese at the 8 ESDN workshop, available at: http://www.sdnetwork.eu/?k=ESDN%20workshops&s=workshop%20documentation&year=2012
38
Potential strategies for facilitating SRIs growth
SRIs are
comparatively
small
The reasons for lack of investment in sustainable development, or more specifically for
SRI investment, are manifold. An investigation of a series of case studies on SRIs
(EUROSIF, 2012) revealed that allocations to SRIs often remain small in comparison to
investors entire assets under management (AuM) due to the following reasons: (i) deal
size; (ii) lack of historical performance data; (iii) lack of knowledge about these
investment areas; (iv) high real or perceived risk levels.
Potential strategies that could further spur the future growth of and removing barriers
for investment on sustainable development can be summarised as follows:
1. Promoting and further developing innovative and successful products and
services with positive environmental and social impact in order to attract clients;
2. Applying robust reporting and assessment, which are key for enhancing the
credibility of sustainable investment;
3. Putting in place regulations in order to remove investment barriers to small-scale
sustainable enterprises.
1. Promoting and further developing innovative and successful products and services
with a positive environmental and social impact to attract clients
According to Weber (2011), two future challenges have to be met in the area of
sustainable banking in order to introduce successful products and services contributing
to sustainable development: firstly, capital must be guaranteed to flow into projects or
businesses that have a positive impact on society, the environment and SD; secondly,
financial mechanisms of products must be designed to meet the goals of sustainable
banks (i.e. to make these products sufficiently profitable to be able to sustain and
increase their outreach and impact). In this context, Weber (2011) concludes that the
further development and widespread application of micro-finance products (e.g. small
loans not relying on typical mechanisms of lending, collateral, and credit history but
rather on mutual guarantees and the willingness of borrowers to be able to provide for
their own costs of living) and SRI funds (see for example the EuSEF best practice case) are
a major step for the growth of investment into sustainable development.
2. Applying robust reporting and assessment, which are key for enhancing the
credibility of sustainable investment
Certainly one way to stimulate sustainable investment in the banking sector, and
investment in general, is to further develop approaches to measuring impacts of
investment (financial as well as non-financial ones), consequently leading to more
informed stakeholders and clients. In terms of sustainable investment, the overall goal is
to inform clients and investors about the impact of the institutions’ products and services
on society and the environment. According to a recent study by the Global Alliance for
Banking on Values(2011), there is a lack of frameworks specifically available for
39
sustainable banks to measure and report their impact in a meaningful and relevant way.
Therefore, further guidance42 for developing a common framework for quantitative and
qualitative reporting would be a supportive step, and essential given the limited
resources available to develop reporting by smaller banks. EUROSIF (2012b) argued that
as investors get to know these investment areas and their associated impacts better,
many have found that the risks associated with these investments may not be as high as
they were initially perceived to be, and that these investments can indeed generate
healthy financial returns (see for example the Obviam and the Norwegian Pension Fund –
Global best practice cases).
3. Putting in place regulations in order to remove investment barriers to small-scale
sustainable enterprises
Concerning SRI, however, the issue of risk plays a crucial role: as most of the enterprises
that have a positive impact on society and the environment are smaller innovative firms
and, therefore, are not traded on stock exchanges, risk associated with these enterprises
is often higher than it is for bigger enterprises. Furthermore, retail investment products
are only allowed to invest in equities that meet certain regulatory standards for reporting
financial issues, for which smaller enterprises do not have the capacity. In order to
balance both the positive societal and environmental impacts, and the financial risk and
return, further cooperation with regulatory bodies could prove successful (Weber, 2011).
In this regard, EUROSIF (2012b) postulates that future national and EU legislation (i.e. the
Europe 2020 Strategy’s focus on green and sustainable growth) might be promising and
one of the main drivers for SRI. One best practice example specifically designed to
overcome barriers for the investment in sustainable SMEs is the creation of specialised
funds, such as the European Social Entrepreneurship Funds Framework and the Swiss
Investment Fund for Emerging Markets. Moreover, as the examples motioned below
indicate, some European Member States are trying to put in place a legal framework to
spur growth in SRI.
In the case of Austria and France, SRI practices and funds are governed by a legal
framework for the certification of funds, in order to facilitate progress towards
transparency. In Germany, for example, legal regulations basically consist of disclosure
requirements. Such legal regulations include the obligation to report on ethical, social,
and ecological criteria taken into account in the use of investments in saving plans. These
were adopted in 2001 for pension funds (Pensionsfonds) and extended to pension
institutions (Pensionskassen), as well as direct insurance (Direktversicherer) in 2005. The
regulations apply to certified products and a broad range of occupational pension
schemes (EUROSIF, 2012b).
Regarding accounting for positive societal and environmental impacts of companies,
national governments can set certain economic incentive structures or regulations in
42
Recent initiatives are undertaken by Global Impact Investors Network’s Impact Reporting and Investment Standards (GIIN
IRIS), European SRI Transparency Code by EUROSIF and ongoing academic work by BRAC Bank
40
order to spur investment in sustainable development oriented issues. One example in
the area of renewable energy, for example, is so-called feed-in tariffs (enacted for
example by the German government through the Renewable Energies Act in 2000),
which account for the additional costs of generation compared to conventional energy
sources. This policy mechanism allows for acceleration in the investment on renewable
energy technologies.
Four major
barriers against
the fundamental
investment shift
towards SD
A more general analysis of the barriers that are hampering the needed substantial shift
of investments towards sustainable development is also offered hereby. Of particular
importance is the intervention of Ariane de Dominicis (DG Environment, European
Commission)43 at the 2012 ESDN workshop “Financial Markets, Institutions and Policies in
the Context of Sustainable Development - Dimensions, Issues and Actors of an Emerging
Arena" that was held in Brussels on the 22nd and 23rd of November. DG Environment
analysed four major barriers against this investment shift:
1. Risks associated with environmental investments. Environmental investments
are often seen as more risky especially because of technology maturity, policy
uncertainty, price of resources and their volatility, and also high capital intensity.
One example of what can be done to overcome this is to produce public money
as leverage and as de-risking financial instrument.
2. Complexity. Investments in SD or resource efficiency appear to be more
complex, especially in terms of novelty, smaller size of projects, and links among
actors that are not used working together. One example to lessen this problem is
through training of the financial sector and business schools to integrate the idea
of SD and resource efficiency. Some instruments should be also developed to
deal with this complexity; one example could be take in consideration: in
Germany, resource efficiency audits to SMEs have been provided and then linked
to the provision of financing to put in place resource efficiency actions. Another
example: at the EU level, it has been developed an instrument called ‘ELENA’ for
energy efficiency, which helps developing projects in urban areas and helping
people working together.
3. Lack of transparency and information on environmental and resource efficiency
aspects. There is a need for comparable data, financial reporting, accounting for
ecosystem services, natural capital, etc., and leadership from the private sector.
4. Bias of the markets towards the short-term, while sustainability is typically a
long-term concept. One thing seems to be especially needed: the long-term
engagement of institutional shareholders.
43
Please refer to the 2012 ESDN Workshop intervention of Ariane de Dominicis available at: http://www.sdnetwork.eu/?k=ESDN%20workshops&s=workshop%20documentation&year=2012
41
Conclusion
The report is mainly based on the content and structure of the Discussion Paper written
for the 8th ESDN Workshop which was held in Brussels in November 2012. The workshop
intended to scope the mechanisms and operational design of financial markets, explore
the functional and dysfunctional aspects from an SD perspective and, on this basis,
develop concrete fields of action for SD policy related to financing, financial markets, and
finance governance. In this perspective, the outcomes and discussions of the workshop
have been included in this report. Very interestingly, five issues were the most vividly
discussed themes during the workshop: firstly, a strong interest was shown towards the
role of the rating agencies within the financial sector, but especially of their effects on
the real economy. Secondly, high importance was recognised in the role of
accountability, disclosure and transparency within the financial sector. In the same
direction, thirdly, the need for more regulation and state intervention was pointed out. A
fourth important aspect that came out in the workshop was the importance of a stronger
focus on investment that supports sustainable projects as well as more investments in SD
in general. Fifthly, a crucial role was recognized for raising awareness of sustainable
development and sustainability themes towards and within the financial sector in order
to help a better alignment and comprehension between the two arenas.
The main goal
In this ESDN Quarterly Report (QR), we had the goal of offering insight into the
relationships, linkages, and differences between the financial sector and the sustainable
development discourse. We started this task by providing a synthetic description of the
financial sector trying to communicate the main financial notions in a language that
aimed at being as simple as possible, with the intention of avoiding an overload of
technicalities. Indeed, the report did not aim to be exhaustive, but aspired to uncover
those links that are particularly relevant for sustainable development and SD governance.
Throughout this description, and especially in the first chapter, few important points
have been highlighted with the intention of portraying the logic behind the financial
sector. First of all, the logic of the financial sector is one-dimensional and it is mainly
related to the maximization of financial profits and, especially, the return on investment.
Nonetheless, it is also important to notice that an efficient financial sector is essential to
a well-functioning economy because it helps to allocate capital and manage risks, and
when this is done in an efficient way, the financial sector provides, therefore, a decisive
service to the economy.
We described the financial sector as formed by the different financial markets and
financial institutions. Financial markets are those in which financial assets (securities) can
be purchased or sold, facilitating the flow of funds and, thereby, allow financing and
investing. Five financial markets can be distinguished: commodity market, money
market, capital market, currency market, and derivatives market. On the other hand,
financial institutions provide financial services for their clients and can be differentiated
into depository and non-depository institutions. Therefore, we tried to portray the links
42
with the ‘real’ economy where we touched upon those crucial issues that mainly relate
to the understanding of how capital is allocated or invested, what reasons determine the
decisions over an investment, and which investments are preferred.
In the second chapter, we mainly focused on the viewpoint of the sustainable
development discourse. Firstly, we provided a brief explanation of the origins of the term
since the description given by the Brundtland commission (1987), which defined
sustainable development as the development that ‘meets the needs of the present
without compromising the ability of future generations to meet their own needs’. Then,
we explained sustainable development in six so-called “SD principles” to better clarify the
concept: 1) Balancing different policy dimensions; 2) Long timeframes and
intergenerational equity; 3) Ecosystems limits and planetary boundaries; 4) Equal
opportunities and access; 5) Inclusion and participation; 6) Governance for sustainable
development.
Through these principles, we have been able to affirm that a number of differences exist
between the sustainable development concept and the financial markets. The crucial
difference between the two arenas is that while sustainable development has a
multidimensional and holistic perspective, in which a balance among environmental
protection, social equity and economic development is pursued, the financial sector
seeks the one-dimensional goal of the maximisation of financial profits. As an important
result out of this confrontation, we developed a ‘Framework for comparing Sustainable
Development and the financial sector’ (please see page 27) that is useful for
understanding the differences, but that also helps to unveil the possible contact points
between these two arenas. Although the financial markets rationale and the sustainable
development discourse seem far apart from each other, we aimed to provide an
overview of possible interventions on the financial sector that could help in reducing the
distances. In terms of regulations, among the interventions that could be implemented,
we found that some were closer to the financial sector rationale and we therefore
suggested few of them: 1) Transaction tax/Tobin tax; 2) Disclosure and Transparency; 3)
Regulate speculation; 4) Bonuses regulation.
Moreover, several suggestions could be made to include the SD perspective into
finance, and therefore we proposed four different ideas: (i) internalization of
externalities in the calculation of an investment (i.e. in a company’s present value); (ii)
assigning a long-term horizon to investments, also as a necessity for maintaining the
prospect of safeguarding financial capital for the future; (iii) progressive substitution of
financial ratios with sustainability ratios; (iv) a changing perspective on the connotation
of financial profits.
43
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46
Annex I
Term
Assets
Bonds
Capital
Central banks
Commercial
banks
Commodity
Credit rating
Debt
Derivatives
Glossary
Definition
Items of value to a business that can be converted into cash. They can be tangible items such as
factories, machinery, or securities or intangible items such as goodwill, the title of a newspaper, or
a product's brand name. They appear on the company's balance sheet.
Legal contracts in which a borrower such as a government, company or institution issues a
certificate by which it promises to pay a lender a specific rate of interest for a fixed duration and
then redeem the contract at face value on maturity. In theory, corporate bonds are safer
than stocks because they have a fixed maturity and are repaid before any payments are made
to shareholders. But if a company fails, its bond holders may suffer just as much as its
shareholders.
Capital refers in a general sense to financial resources such as cash or securities or, more
specifically, to assets which can be liquidated and turned into cash.
The major regulatory bank in a nation or group of nations' monetary system. Its role normally
includes control of the credit system, the issuing of notes and coins, and supervision of commercial
banks. It also manages its country's foreign exchange reserves and acts as its government's banker.
Central banks in developed economies are also responsible for the conduct of monetary policy.
Financial institutions that operate both in the wholesale banking and retail banking markets.
Commercial banks attract customer deposits and offer cheque-clearing facilities and also handle
the business of large companies and financial institutions. They are allowed to borrow from their
respective central banks when they need short-term funds. Commercial banks contrast with
investment or merchant banks, which specialize in raising funds for companies rather than
concentrating on lending and the transmission of money.
Raw materials used in the production of foodstuffs and in manufacturing industries. Commodities
include metals, grains and cereals, soft commodities such as sugar, cocoa, coffee, and tea and
vegetable oils such as palm oil, soya bean oil, and sunflower seed oil. Exchange-traded
commodities are quoted in specific lots of a specific quality for specified delivery. Commodities are
also traded in futures and options markets.
Credit ratings measure a borrower's creditworthiness and provide an international framework for
comparing the credit quality of issuers and rated bonds. Rating agencies allocate three kinds of
ratings: for issuers, for long-term debt, and for short-term debt. Of these, issuer credit ratings are
the most widely watched. They measure the creditworthiness of the borrower including its
capacity and willingness to meet its financial obligations. A top rating means there is thought to be
almost no risk of the borrower failing to pay interest and principal. Ratings are derived from an
examination of a company or a government's past financial history, its current assets and
liabilities and its future prospects. The higher the rating the less the borrower will need to pay for
funds.
An obligation to repay a sum of money. More specifically, it is funds passed from a creditor to a
debtor in exchange for interest, and a commitment to repay the principal in full on a specified
date. Bonds and other debt instruments have a defined life, a maturity date, and normally pay a
fixed interest rate or coupon.
Securities or financial instruments whose value is derived from the value of another, underlying
asset. They can be bought, sold, and traded in a similar way to shares or any other financial
instrument. The underlying assets or instruments on which derivatives can be based include
commodities, equities, residential mortgages, commercial real estate, loans, bonds, interest
rates, exchange rates, stock market indices, consumer price indices, and weather conditions. The
main types of derivatives are forward contracts, futures, options and swaps. Credit derivatives are
based on loans, bonds or other forms of credit. The pricing and performance of derivatives is often
based on that of the underlying asset, although the reverse may also be true. Derivatives can drive
the underlying market and the volumes traded in certain futures and options contacts can exceed
those in the underlying cash markets. Derivatives can be traded on an exchange or in an over-the-
47
Equity
Financial
intermediation
Financial
markets
Inflation
Investment
bank
Interest rates
Maturity
Monetary
policy
Money market
Over the
counter (OTC)
Present value
Speculation
Stock
counter (OTC) market. Global derivatives traded market volume is in the hundreds of trillions of
dollars annually.
The holding or stake that shareholders have in a company. Shareholders equity is calculated by
subtracting total liabilities from total assets. Equity capital raised by the issue of shares is one of
the two main sources of finance for a company - the other is debt.
Bringing together users of capital, such as businesses and governments, with suppliers of capital
such as pension funds and private investors. The term is usually used to describe the activities of
commercial and investment banks.
Markets in which funds are transferred from people who have a surplus of available funds to
people who have a shortage of available funds
A persistent rise in the prices of goods and services.
A financial institution that raises capital for clients, that trades in securities and financial
instruments for clients and on its own account and advises on corporate mergers and acquisitions
(M&A).
The charge or the return on an asset or debt expressed as a percentage of the price or size of the
asset or debt. It is usually expressed on an annual basis.
The length of time between the issue of a bond or other security and the date on which it becomes
payable in full. Most bonds are issued with a fixed maturity date. Those without one are known as
perpetuals.
Government policy that deals with the availability and cost of money. It is changed by making
adjustments to the money supply and the level of short-term official interest rates. Monetary
policy has a direct effect on the overall level of economic activity and inflation. Governments often
delegate the implementation of monetary policy to their country's central bank.
A wholesale market for the buying and selling of money. Money markets normally trade in short
term debt instruments with maturities of 12 months or less. Most activity is by banks borrowing
and lending to each other and interest rates are often set with reference to the London Interbank
Offered Rate (LIBOR). Instruments traded on the money market include banker's
acceptances, CDs, repurchase
agreements, treasury
bills,
commercial
paper, eurodollar deposits, municipal notes, and fed funds.
Abbreviation for Over The Counter. An OTC market or trade is one conducted directly between
dealers and principals via a telephone and computer network rather than via an exchange. In
contrast to exchange trading, there is no automatic disclosure of the price of deals to other market
participants and deals and traded instruments are not standardised. With a trade on an exchange,
a clearing house steps in when a counterparty defaults, ensuring that the transaction is completed.
But most OTC trades are not cleared, exposing firms – and the financial system – to counterparty
risk. As of 2009, there is increasing political pressure for OTC trades to move to public exchanges
and be handled by clearing houses.
The current value of future cash flows, discounted at an appropriate interest rate. Cash earned in
the future is worth less than cash earned now because today's cash can be invested and can earn
interest.
The taking of relatively high risks and the acceptance of the possibility of losses in the hope of
making large gains. It may involve the purchase or the short-selling of securities or assets in the
hope of profiting from relatively short term price changes. Speculators normally, though not
always, have no professional interest in the securities or assets they trade in. Speculation can be
contrasted with investment, which is the long term purchase of assets or securities in the hope of
income and capital appreciation. Speculation is sometimes referred to in a pejorative sense.
However, speculative trading adds capital and liquidity to financial markets, and reduces price
fluctuations in normal times. In periods of economic or political crisis, it is likely to exaggerate
market movements.
The amount of money employed by a company in its work-in-progress, raw materials, and finished
goods, also known as inventory. The word can also refer to a certificate that represents part
ownership of a company and the right to receive a share in the profits of the company. Also called
a share.
48
Annex II
Interview with Stefania Rossi, University of Cagliari
Stefania Rossi (Professor of Macroeconomics and Financial Markets, Department of Economics,
University of Cagliari, Italy)
1. What are the different logics in sustainable development and of financial markets?
In 1987, the World Commission on Environment and Development defined the concept of Sustainable
Development as “the development that meets the needs of the present without compromising the
ability of future generations to meet their own needs”. This means that when we talk about Sustainable
Development we need to take into consideration the long-run investment strategies and economic
policy effects, including the negative externalities for agents, firms, environment, production factors and
their availability. In other words, the long-term perspective of sustainable development, seeks to
integrate investment objectives and strategies with social and environmental issues.
Conversely, financial sector responds to a different logic, which is not necessarily longsighted. We rather
observe that financial markets are more centred on the short-term profit maximisation and return on
investment. Albeit, financial markets create social value through the efficient allocation of capital to
firms and households, concern on the external effects of financial strategies and investments decisions such as environmental protection, welfare and social aspects, intergenerational and intra-generational
equity issues – was and is not a priority.
2. What are the causes of these differences? (i.e. actors, regulations, history of the crises)
Finance is lifeblood for the economy. As such, it can also affect sustainability and social responsibility of
the firm. For example, the World Business Council for Sustainable Development sees the financial
industry as a main actor in promoting sustainability. We all know that from an ethical and normative
point of view, socially responsible investors and shareholders shall promote socially and environmentally
desirable economic activities. On the other side, we know that economic behaviors and economic agents
respond to incentives.
Financial markets, as well, respond to economic/financial incentives: for instance, capital flows towards
investments that give higher returns. In my view, the crucial and right point to investigate is about the
presence of incentives that promote more socially responsible investing. In trivial words, did
sustainable financial investments deliver lower or higher financial returns? So far, academic research
finds that the theoretical arguments, as well as, the empirical evidence do not provide convergent
outcomes. Financial performance seems only weakly linked to corporate social responsible behavior and
socially responsible investments do not earn significantly higher returns than investments that do not
take account of firm’s behavior. In my opinion, this has been a reason to qualify the incentives of
shareowners towards sustainable financial investment rather limited. Additionally as long as manager’s
performance is mainly judged on short-term Performance indicators, managers have no incentive to
invest in sustainable investments. Finally, I would also underline that in presence of market failure,
policy should play a role in stimulating and promoting incentives that are able to fulfil sustainable
development goals.
49
3. What do you suggest to avoid crises at financial markets in the future and to implement
sustainable development principles at financial markets?
Generally, financial markets deal with two kinds of information asymmetries: 1) adverse selection
(lenders may not be able to properly evaluate investments and choose among them); and, 2) moral
hazard (meaning that banks do not bear the full cost of their actions). In my view, a financial system that
is better shaped to deal with these asymmetries would be required. Mainly, we need to face the
problem of moral hazard, arising in presence of large financial institutions, so-called ‘Too Big To Fail’
(TBTF). The status of ‘Too Big To Fail’ confers an implicit guarantee that twists large banks to abandon
prudential conducts in favor of excessive risk taking and opportunistic behaviors (more risky credit
policies, low liquidity levels and shrinking of capital): in case of bank default the loss will be paid by tax
payer and collectivity. Moreover, those large financial institutions are not only too big to fail, but also to
big for being regulated. In order to avoid future financial crises and to implement SD principles at
financial markets I would suggest the following recommendations.
Firstly, we should introduce a framework of regulations for preventing the creation of the ‘Too Big To
Fail’ banks or too large financial institutions. Research shows that these ‘too big to fail’ financial
institutions, in some case, are not even able to exploit economies of scale and scope, which should
represent the economic rationale for their constitution and existence. On the contrary, their failures or
defaults – because of their size – can create domino effects in the financial markets with detrimental
effects on the real sector. Eventually, it is also shown that smaller banks are better capitalized and have
better knowledge of firms, households and the local economy in which they are embedded.
Secondly, in some way related to the moral hazard problem (‘Too Big To Fail’), there is also the issue of
regulating speculation, particularly big speculators, with the intention of better preserving financial
stability.
Thirdly, an additional recommendation, which is also discussed at the European level, is the introduction
of a transaction tax that, penalizing short-horizon investment, will aim at reaching more stability in
financial markets, introducing more fair rules (i.e. the financial markets did not fully pay the cost of the
crisis), and harmonizing laws among Member States.
Finally, I would suggest introducing more transparency and accountability, not only on information,
decision processes, and governance, but also on financial products and instruments to avoid financial
innovations that mask risk.
4. Who should take action? What should be done first?
Indeed all the measures discussed above are dealing with markets that are highly and deeply
interdependent; therefore a strong commitment that involves the responsible institutions and
authorities at the European and International level is required. In my view, the first action would be to
set up a framework of regulations aiming at preventing market failure and introducing incentives able
to promote market stability.
50
5. Could you please describe how the financial crisis led to an economic crisis and to a crisis of
the political system and to a social crisis?
As well known, the 2007-2009 financial crisis had its origin in the U.S. with the so-called subprime
mortgage crisis, “where an asset price bubble interacted with new kinds of financial innovations that
masked risk; with companies that failed to follow their own risk management procedures; and with
regulators and supervisors that failed to restrain excessive risk taking” (Baily et al., 2008) 44. The financial
crisis was spread from the U.S. across the world and then transmitted to the real sector through the
following traditional mechanisms:
 loss of confidence of banks (crisis of the inter-banking market: banks don’t trust each other);
 loss of confidence of household and increased liquidity preferences;
 credit crunch, decrease of supply of credit, but also of demand of credit because of pessimistic
expectations;
 decrease of investment and income;
 increase of unemployment rate;
 reduction of households financial wealth (stocks and bonds) and private saving;
 decrease in the world demand and exports, which for some countries are crucial for growth.
In the EU at beginning of 2010, the financial crisis turned into a second wave of crisis, known as the
‘public debt crisis’. At that time appeared clear that the Greek Government, in order to satisfy the
Maastricht parameters, had manipulated the public accounting data to hide the entity of public debt.
The public deficit and public debt figures had to be revaluated. The contagion involved Ireland, Portugal,
Spain, and then Italy. The entire Eurozone was under speculative attack. All the EU Member States (with
some remarkable differences) committed to an extensive austerity program and fiscal consolidation
plan. These simultaneous austerity policies in the EU have even amplified the financial and real crisis
effects on all economies. In particular, due to the budgets constraint and the austerity policy, which in
most cases produced cut on the welfare and social expenses, the crisis manifested its severity across the
more vulnerable social classes. The real and the social crises had two important side effects, which are
also not consistent with sustainable development: 1) increase in income inequality (income gap
between the wealthy and the poor people); 2) loss of inter- and intra-generational equity (the young
generations have less opportunities in terms of employment, income or pension and a lower prospect
for better life conditions than the older generation).
6. How are Sustainable Development relevant issues affected by the financial crisis?
As discussed above, the financial crisis affected also the relevant issues in SD. The financial crisis of 2008
is just the latest and most dramatic proof that finance, which assumed a prominent role, acts and
responds to a different and less socially-conscious meaning than other sectors. Nevertheless, we can
argue that this financial crisis represented also an opportunity and an obligation for regulators, policy
makers, financial agents, researchers to practice finance differently. This is the reason why, nowadays,
policy makers, financial actors and authorities discuss about “sustainable finance”, which is the practice
44
Baily, M.N., R.E. Litan and M.S. Johnson (2008) The Origins of the Financial Crisis. Brookings Institution, Fixing Finance Series,
Paper No. 3.
51
of creating economic and social value through financial models, products and markets that are
sustainable over time.
In this post-crisis contest, also the role of banks needs to be revised in order to modelling financial
institutions that are more suited to enhance social, environmental and sustainable development goals. A
Sustainable banking sector, according the principle of the Global Alliance for Banking on Values (GABV),
should therefore be more focused on the real economy, offer resiliency through strong capital positions,
deliver stable and solid financial returns (i.e. importance of incentives), and should also boost economic
growth. In addition, we can argue that sustainable banks should be not ‘too big’, and better managed for
reducing information asymmetries and monitor their own risk management procedures.
7. In what ways is the financial sector linked with the real world economy?
Firstly, financial markets and intermediaries add value to the real sector by offering a number of services
to savers and investors: for instance, payment services, asset management, risk management, borrowers
monitoring and so on. Secondly, the financial sector is also linked to economic growth through several
transmission channels: (i) a fraction of saving goes to investment in the real sector (i.e. regulators can
have an impact on this fraction for instance through reducing the losses in the information processes);
(ii) marginal productivity of capital (i.e. the financial sector can improve this productivity); (iii) impact on
the saving rate (i.e. higher financial development can insure against shocks and give families the chance
to diversify wealth). In addition, screening, monitoring and enforcement are very important aspects of
the financial sector to improve the efficiency of the real economy.
8. Do you see possible actions towards a financial sector that is more oriented and aligned with
sustainable development?
These two questions are very much linked together. The global scenario changed vastly after the recent
financial and economic crises with a larger interest towards sustainability showed by capital markets. For
instance, sustainable investments have increased substantially, registering a 36% of annual growth rate
(as shown by EUROSIF) and their market is expected to grow even more. Additionally, these trends in
financial markets are also supported by new empirical studies, which show a greater focus towards
sustainable development by financial markets and by business practices.
Furthermore, the big change occurring in financial and real sectors towards sustainable development
are not only driven by ethical provisions but they are also forced by the scarcity of natural resources, for
instance the limited availability of crude oil coupled with steadily increasing energy demand.
Albeit financial and real markets are moving towards a more sustainable development oriented
paradigm, we still witness some paradoxes. For instance, while, on the one hand, financial markets
investors seem to be more aware about sustainable investing and environmental issues, and the real
sector is investing in the green economy, on the other hand, current global carbon emissions are
increasing more than global GDP growth rate, and are the main responsible for global warming.
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Annex III Interview with Alexander G. Welzl, Economica
Alexander G. Welzl45 (senior researcher with Economica, Vienna/Austria)
1. What are the different logics in sustainable development and of financial markets?
In my comments I just want to cover some of the characteristics in a field, which is rather complex and
addresses a multitude of different aspects. Being a natural scientist by education and now an economic
researcher by profession – with professional experiences in the financial industry, public financial
administration, private industry as well as non-profit organizations dealing with environmental issues – I
had the opportunity to look on the phenomena of sustainable development as well as financial markets
with an insight view in the respective communities throughout the last 25 years. Let me therefore be not
too theoretical but providing my answers based on a mixture of methodological know-how and practical
experience. Many of the things I point out have repeatedly been addressed in public by experts from
both realms in the recent years following the global crisis. They are by far not new or unique with regard
to the analysis. However the sense of urgency still seems to be not strong enough to go for a
fundamental re-launch especially of the global financial system and markets.
From my perspective there are a few basic differences. First of all we have to understand that each of
the communities have their own language sometimes even using the same words or phrases however
with a totally different connotation. In general knowledge about and practical insight in rules,
procedures and institutional context of ‘the other side’ is scarce within each of the communities.
A major and fundamental difference between a sustainability approach and the rationale of financial
markets is the contradiction between a necessary long-term perspective when it comes to sustainable
forms of living on the one hand and the intrinsic short-termism in the financial markets on the other
hand.
Secondly sustainability as a concept of living and doing business includes a focus on the value and
development of public goods as well as the continuous strengthening of community well-being. In the
financial industry the paradigm of individualization of gains versus socialization of losses create
framework conditions, which quite logically lead to a totally different development and nurture
completely other forms of lifestyles and ways of doing business. This has also been addressed quite
frankly in the 79th Annual Report (2009) of the Basel based Bank of International Settlements (BIS) which
is kind of an umbrella organization of all National Banks worldwide.
Sustainability is also linked to an awareness of the necessity of negative feedback-loops with regard to
growth and use of limited resources. In turn continuous growth is a basic paradigm in financial
markets. This contradiction is linked to another one: the quest for a valuation framework of human
development guided by ecosystemic limits and framework conditions (as far as we understand them)
versus the artificial anthropogeneous system of financial markets.
Another point of different logic is the definition of success and successful developments. In sustainability
context attempts are made to understand linkages of individual activities and potential harmful impacts
in societal and ecological context. The logic of financial markets tends to decouple of individual action
and responsibility for potential harmful outcome in economic and societal context and in daily business
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The opinions expressed in this interview are those of the author and do not necessarily reflect the position or views of
Economica.
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ecological aspects don’t play a role so far. Attempts to create incentives for responsible and long-term
oriented behavior with regard to sustainable business practices stand against real market practice of
incentives geared towards short-term, individualized and maximum gains. These characteristics are
linked to an interest of the informed sustainability community in the development of an enlarged set of
performance measures including quantitative (monetary) and qualitative elements (metrics) and new
accounting approaches. Financial market professionals on the contrary support accounting and valuation
practices based on monetary valuation alone and are in general reluctant to seriously integrate new
accounting approaches and metrics on a broader and compulsory basis.
2. What are the causes of these differences? (i.e. actors, regulations, history of the crises)?
One major reason is educational background and missing knowledge of financial professionals
regarding ecosystemic framework conditions and historic context of former crises. Another reason is
the difference in socialization and psychological framework conditions of the two communities. For
instance, financial professionals tend to impose their rules and cycles onto corporations even if they do
not fit into the reality of real economies logic and production cycles (see for instance the book of Karen
Ho ‘Liquidated – An Ethnography of Wall Street’) whereas the rationale in the sustainability community is
to try to implement more holistic and integrative approaches.
Regarding SEC in the US the way how regulation is performed works in a political context and under
framework conditions provided by the dominating economic paradigm. If there is a paradigm that too
much transparency and monitoring of risk might lead to inefficiency and hinders the markets than
regulators would act in this context. The difference to the sustainability context is that no comparable
regulatory institution of the same power like SEC and others has been established so far and until today
the discussions still go on between those in favor of strict and transparent regulations and those who are
strictly in favor of non-regulated voluntary reporting and valuation practices. This shows the complicated
situation after a public debate regarding sustainability of roughly 40 years.
3. What do you suggest to avoid crises at financial markets in the future and to implement
sustainable development principles at financial markets?
First of all, it is important to set realistic goals and adjust expectations to the real learning capacity of
individuals working in the financial markets. Observations of financial market professionals in the
recent 30 years and again in the aftermath of the global financial crisis show that the general learning
curve is not very steep when it comes to understand basic principles of sustainable development in
general and the consequences for the financial industry in specific.
Secondly, one has to take into account that financial professionals tend not to accept logics,
framework conditions or metrics that are suggested to them by other expert communities. This again is
characteristic for the way how financial industry has embraced the notion of sustainability up to now.
Instead of learning about the principles of ecosystemic sustainability representatives of the financial
industry simply take phrases and words like ‘sustainability’ and reframe them in the context of their
industry. In this process the words are used but they are used based on an understanding and definition
that stems from a financial industry context. For instance driving forces for the global implementation of
XBRL – which is the ultimate instrument for short-term information retrieval of corporate performance –
at the same time want to include sustainability metrics in the online XBRL-information retrieval system.
Although this is a very obvious and basic contradiction in the context of financial industry sustainability
with regard to metrics evolves to just another set of data representing information from the realm of socalled extra-financials. Therefore further initiatives, development and implementation of procedures,
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methods and electronic platforms aiming at an even stronger acceleration of information exchange
between financial institutions, professionals and listed corporations should be stopped. As a
consequence XBRL and comparable approaches should be forbidden by regulators.
Finally, a change of incentive structures in corporations and financial industry is crucial. This means in a
first major step renewal of executive compensation schemes geared towards inclusion of performance
metrics focusing on mid- to long-term corporate development and value creation.
4. Who should take action? What should be done first?
Regarding a long-term cultural change first of all the curricula at business schools have to be renewed
substantially. New curricula elements amongst others have to include obligatory courses and training in
economic history in general with a particular focus on former crises, psychology of financial markets,
responsibility of the financial industry and markets for development of corporations and societal
development as well as new accounting approaches including all types of intangible assets. Extensive
thoughts about a new conceptional approach to economic education and development of curricula at
universities of economy and business administration are continuously published amongst others by the
Institute of New Economic Thinking founded by George Soros and leading academics and professionals in
economy and finance. Another important first step would be the introduction of a more serious form of
risk assessment (including societal and environmental impact of investment decisions).
5. In which ways Sustainable development principles differ from the principles of financial
markets? Where do you see basic contradictions between them?
Financial market circles aiming at short-termism or at expectations of exceptional returns - even if this
does not have to do anything with reality in growth capacity of corporations - create harmful pressure on
boards and employees. Transparency of business processes with regard to risk potential for society and
environment is a basic claim or principle of sustainable.
6. In terms of valuation and key principles of valuation (i.e. strict lowest-value principle, marketvalue principle, present-value principle), what consequences do these valuation principles
have for financial markets, for the real economy and for sustainable development?
In general, valorization approaches covering quantitative metrics that are based on monetizing values,
only fail to be useful in the context of sustainable development. In a global business landscape where
knowledge and innovation have to be seen as assets and framework conditions of the biosphere as
natural opportunities and limits at the same time the language of the financial industry - i.e. corporate
accounting, accounting standards as well as financial analysis and due diligence processes – has to be
fundamentally changed.
7. How can you valuate intangible assets? And, which aspects of intangible assets valuation are
mainly linked to sustainable development?
There are several approaches to the valuation of intangibles. Basically two major solutions can be
distinguished: a) monetarisation of intangibles; or, b) the attempt to develop a new system of metrics,
reporting language and use of this information based on qualitative and quantitative data. In the latter
case scoring systems, quality measurements as well as comparison of an achieved progress against midand long-term goals would be used. However this requires investment professionals, analysts, financial
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service firms and corporate managements to use these metrics and integrated information. There are
experiences with specific intangible assets like patents to be used as loan collateral by banks. This
includes valuation procedures accepted and implemented by corporations as well as by the financial
professionals. Current examples of this maybe found in China and they are part of the implementation of
a strategic government plan to foster domestic innovation capacity.
8. In what ways is the financial sector linked with the real world economy?
As the BIS described it to the point the financial industry is the economy‘s plumbing system’ (BIS Annual
Report 2009). Let me therefore quote some parts of this historic Annual Report of the Bank of
International settlements46:
“The financial system is the economy’s plumbing. And like the plumbing in a house, it is taken for
granted when it works, but when it doesn’t, watch out. In the same way that modern living depends on a
reliable flow of water running through pipes, the modern economic system depends on a reliable flow of
financing through intermediaries. What a difference two years make. Since August 2007, the financial
system has experienced a sequence of critical failures. How could this happen? No one thought that the
financial system could collapse.
A financial crisis bears striking similarities to medical illness. In both cases, finding a cure requires
identifying and then treating the causes of the disease. Looking at the past few years, we can divide the
causes of the current crisis into two broad categories: macroeconomic and microeconomic. The
macroeconomic causes fall into two groups: problems associated with the build-up of imbalances in
international claims and difficulties created by the long period of low real interest rates. The
microeconomic causes fall into three areas: incentives, risk measurement and regulation.
The financial stress that began in the summer of 2007 has revealed a myriad of limitations in
microeconomic financial arrangements. The crisis has revealed distorted incentives for consumers, for
financial sector employees and for rating agencies. Few people have any knowledge of the balance
sheets of the banks where they do business (…). And the overall level of financial literacy among the
general population is low. This lack of knowledge combined with the existence of financial oversight
structures made people all too willing to mistake the complexity of the system for sophistication. And it
made them all too willing to assume that their investments were safe. After all, someone else was
watching – be it a trusted manager, an equity analyst, a credit rating agency or a government official. But
none of them were. The system that consumers so readily assumed was sophisticated and safe was, in
fact, recklessly complex and opaque. Compensation schemes further encouraged managers to forsake
longrun prospects for short-run return. In some cases, profits calculated with complex mathematical
models were used to determine rewards even when markets for the assets underlying the calculations
did not exist and so they could not be sold. Equity holders (because of limited liability) and asset
managers (because of their compensation system) were unduly rewarded for risk-taking: they received
a portion of the upside, but the downside belonged to the creditors (or the government!). In the end,
the overall difficulty in distinguishing luck from skill in the performance of asset managers, combined
with compensation based at least in part on the volume of business, encouraged managers and traders
to accumulate huge amounts of risk.
46
See also my lecture at the University of Oxford in 2009:
http://www.esce.at/economica/index.php?mact=News,cntnt01,detail,0&cntnt01articleid=23&cntnt01returnid=15
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Added to failures in monitoring by individuals and flawed compensation schemes were the skewed
incentives of the rating agencies. There are a number of problems with this system.”
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European Sustainable Development Network (ESDN)
www.sd-network.eu
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